Models of Economic Growth B

Outline:
1. Endogenous growth models
Slides 1-22 (these slides offer a slightly
more detailed treatment of endogenous
models than Chapter 8)
2. The convergence debate
Slides 23 34 (this is additional to
material covered in the book)

Endogenous growth models topics

Recap on growth of technology (A) in Solow model
(..does allow long run growth)
Endogenous growth models
Non-diminishing returns to capital
Role of human capital
Creative destruction models
Competition and growth
Scale effects on growth

Exogenous technology growth

Solow (and Swan) models show that technological change
drives growth
But growth of technology is not determined within the model
(it is exogenous)
Note that it does not show that capital investment is
unimportant ( A y and MPk, hence k)
In words . better technology raises output, but also creates
new capital investment opportunities
Endogenous growth models try to make endogenous the
driving force(s) of growth
Can be technology or other factors like learning by workers

The AK model
The AK model is sometimes termed an endogenous
growth model
The model has Y = AK
where K can be thought of as some composite capital
and labour input
Clearly this has constant marginal product of capital
(MPk = dY/dK=A), hence long run growth is possible
Thus, the AK model is a simple way of illustrating
endogenous growth concept
However, it is very simple! A is poorly defined, yet
critical to growth rate
Also composite K is unappealing

The AK model in a diagram

Endogenous technology growth

Suppose that technology depends on past
investment (i.e. the process of investment generates
new ideas, knowledge and learning).

dA
A g (K )
where
0
dK
Specifically, let A K

0
Cobb-Douglas production function

Y AK L1 [ K ]K L1 K L1
If + = 1 then marginal product of capital is
constant (dY/dK = L1-

 Assuming A=g(K) is Ken Arrows (1962)

learning-by-doing paper
Intuition is that learning about technology
prevents marginal product declining

Situation on growth diagram

Distance between lines

represents growth in capital
per worker

Increasing returns to scale

Y K

with 1

Problem with Y = K1L1- is that it exhibits

increasing returns to scale (doubling K and L,
more than doubles Y)
IRS large firms dominate, no perfect
competition (no P=MC, no first welfare theorem,
..)
. solution, assume feedback from investment
to A is external to firms (note this is positive
externality, or spillover, from microeconomics)

Knowledge externalities
A firm's production function is

1
i
i

Yi Ai K L

but Ai depends on aggregate capital

(hence firm does not 'control' increasing returns)
Romer (1986) paper formally proves such a model
has a competitive equilibrium
However, the importance of externalities in
knowledge (R&D, technology) long recognised
Endogenous growth theory combines IRS,
knowledge externalities and competitive behaviour
in (dynamic optimising) models

More formal endogenous growth models

Romer (1990), Jones (1995) and others use a model
of profit-seeking firms investing in R&D
A firms R&D raises its profits, but also has a positive
externality on other firms R&D productivity (can have
competitive behaviour at firm-level, but IRS overall)
Assume Y=K(ALY)
Labour used either to produce output (LY) or
technology (LA)
As before, A is technology (also called ideas or
knowledge)
Note total labour supply is L = LY + LA

Romer model
dA
Assume
LA A
>0
dt
This is differential equation. Can A have constant growth rate?
Answer: depends on parameters and and growth of LA
Romer (1990) assumed:
1, 1
dA
hence
LA A
dt
dA

/ A LA (>0 if some labour allocated to research)

dt
If A has positive growth, this will give long run growth in GDP p.w.
Note that there is a 'scale effect' from LA

Note knife edge property of =1. If >1, growth rate will accelerate over
time; if <1, growth rate falls.

Jones model (semi-endogenous)

0, 1 (Jones, 1995)
dA
dA
A& LA A LA

Now
LA A

/ A
= 1
dt
dt
A
A
A
Can only have positive long run growth if far right term is constant
L&A
A&
A&
L&A
This only when
(1 )
or

LA
A
A (1 ) LA
In words: growth of technology = constant labour growth

No scale effects, no knife edge property, but

requires (exogenous) labour force growth hence semiendogenous (see Jones (1999) for discussion)

Human capital the Lucas model

Lucas defines human capital as the skill
embodied in workers
Constant number of workers in economy is N
Each one has a human capital level of h
Human capital can be used either to produce
output (proportion u)
Or to accumulate new human capital
(proportion 1-u)
Human capital grows at a constant rate
dh/dt = h(1-u)

Lucas model in detail

The production of output (Y) is given by
Y = AK (uhN)1- ha
where 0 < < 1 and 0
Lucas assumed that technology (A) was constant
Note the presence of the extra term h a - this is
defined as the average human capital level
This allows for external effect of human capital that
can also influence other firms, e.g. higher average
skills allow workers to communicate better
Main driver of growth - As h grows the effect is to
scale up the input of workers N, so raising output Y
and raising marginal product of capital K

Creative destruction and firm-level activity

many endogenous growth models assume profitseeking firms invest in R&D (ideas, knowledge)
Incentives: expected monopoly profits on new product or
process. This depends on probability of inventing and, if
successful, expected length of monopoly (strength of
intellectual property rights e.g. patents)
Cost: expected labour cost (note that cost depends on
productivity, which depends on extent of spillovers)

models are monopolistic competitive i.e. free entry into

R&D zero profits (fixed cost of R&D=monopoly
profits). Creative destruction since new inventions
destroy markets of (some) existing products.
without knowledge spillovers such firms run into
diminishing returns
such models have three potential market failures,
which make policy implications unclear

Market failures in R&D growth models

1. Appropriability effect (monopoly profits of a new
innovation < consumer surplus) too little R&D
2. Creative-destruction, or business stealing, effect
(new innovation destroys profits of existing firms),
which private innovator ignores too much R&D
3. Knowledge spillover effect (each firms R&D helps
reduce costs of others innovations; positive
externality) too little R&D
The overall outcome depends on parameters and
functional form of model

What do we learn from such models?

Growth of technology via knowledge spillovers vital
for economic growth
Competitive profit-seeking firms can generate
investment & growth, but can be market failures
(social planner wants to invest more since spillovers
not part of private optimisation)
Spillovers, clusters, networks, business-university links
all potentially vital
But models too generalised to offer specific policy
guidance

Competition and growth

Endogenous growth models imply greater competition,
lower profits, lower incentive to do R&D and lower growth
(R&D line shifts down)
But this conflicts with economists basic belief that
competition is good!
Theoretical solution
Build models that have optimal competition
Aghion-Howitt model describes three sector model (escape
from competition idea)

Intuitive idea is that monopolies dont innovate

Do scale effects exist

Romer model implies countries that have more labour
in knowledge-sector (e.g. R&D) should grow faster
Jones argues this not the case (since researchers in US
5x (1950-90) but growth still 2% p.a.
Hence, Jones claims his semi-endogenous model
better fits the facts, BUT
measurement issues (formal R&D labs increasingly used)
scale effects occur via knowledge externalities (these may be
regional-, industry-, or network-specific)
Kremer (1993) suggests higher population (scale) does
increase growth rates over last 1000+ years

anyhow. both models show (the knowledge

spillover parameter) is important

Questions for discussion

1. What is the knife edge property of
endogenous growth models?
2. Is more competition good for economic
growth?
3. Do scale effects mean that Chinas growth
rate will always be high?

References
Arrow, K. (1962). "The Economic Consequences of Learning by Doing." Review of
Economic Studies XXIX(80): 155-173.
Jones, C. (1995). "R&D Based Models of Economic Growth." Journal of Political
Economy 103(4): 759-784.
Jones, C. (1999) "Growth: With or Without Scale Effects?" American Economic Review
Papers and Proceedings, 89, 139-144.
Kremer, M. (1993). "Population Growth and Technological Change: One Million B.C. to
1990." Quarterly Journal of Economics 108: 681-716.
Lucas, R. E. (1988). "On the Mechanics of Economic Development." Journal of Monetary
Economics 22: 3-42.
Mankiw, N., D. Romer, et al. (1992). "A Contribution to the Empirics of Economic Growth."
Quarterly Journal of Economics 107(2): 407-437.
Romer, P. (1986). "Increasing Returns and Long Run Growth." Journal of Political
Economy 94(2): 1002-1037.
Romer, P. (1990). "Endogenous Technological Change." Journal of Political Economy
98(5): S71-S102.

Convergence debate
Following slides discuss the above issue, which is not
included in detail in book
However, it may be a topic to include in a course on
macroeconomics of growth, see:
Milanovic, B. (2002). "Worlds Apart: Inter-National and World
Inequality 1950-2000". World Bank, [Link]
.org/research/inequality/world%20income%20distribution/wo
rld%20apart.
pdf.
Pritchett, L. (1997). "Divergence, Big Time." Journal of
Economic Perspectives 11(3): 3-17.
Stiglitz, J.-E. (2000). "Capital Market Liberalization,
Economic Growth, and Instability." World Development
28(6): 1075-86.

Do poorer countries grow faster? (the

convergence debate)
Two common ways to assess convergence
1. Beta () convergence
2. Sigma () convergence

-convergence (use regression analysis)

growthi = constant + (initial GDP p.w.)i
(i stands for a country. Test on sample of 60+)
If <0, poorer countries, on average, grow faster
-convergence
measure dispersion (variance) of GDP per worker across
countries in a given year. If dispersion falls over time can
say countries converging.

BWA

TWN
KOR

HKG

SGP
IRL

JPN

LUX
GRC

USA

ARG

-2

PER
MRT
AGO

NZL

CHE

VEN

NIC

ZAR

-4

Growth in GDP per worker 65-2000(or 95)

-convergence, 110 countries, 1965-2000

Source: PWT 6.1

10000
20000
30000
Real GDP per worker in 1965 (US$,PPP 96 prices)

Estimated for above = 0.000. No beta convergence

40000

Problems and other evidence

There are more than 110 countries (UN 191). The
poorest countries often dont have data. Hence
above result could be mis-leading.
L Pritchett (1997) Divergence, Big Time.
1870-1990, rich countries got much richer
9/1 ratio in 1870; 45/1 ratio in 1990

Some view the 1960s-80s as good decades for

poorer countries normally divergence
Conditional convergence.
If regression analysis controls for other factors (e.g.
investment), poorer countries do grow faster.
Not very surprising . what are other factors?

sigma () convergence
Variance (110 countries GDP per worker) increases
over time divergence since 60s
But, if you weight countries according to population,
evidence shows convergence (this appears entirely
due to China, Milanovic, 2002, see next slide)
(note: if you do not weight you give China and, say,
Togo the same importance or weight)
Finally, researchers now working on true world
inequality data (i.e. combine within country, and across
country, inequality). Initial results show world
inequality increasing since late 1980s

Gini measure of inter-country inequality

Source: Data direct from Branko Milanovic, see Milanovic (2002). The higher
the Gini-coefficient, the more unequal is GDP per capita across the world (see
endnotes)

Twin peaks ?
.3

Some evidence that world income distribution is moving to twinpeaks distribution but not very strong
1995 real GDP per worker

.1

Fraction

.1

.2

Fraction

.2

.3

1965 real GDP per worker

10000

20000
30000
40000
Real GDP per worker, US$ 1996 prices

10000

20000
30000
40000
Real GDP per worker, US$ 1996 prices

50000

60000

50000

60000

What are mechanisms driving

convergence?
Important to understand basic data, but real
issue is mechanisms
Consider some theory initially
open economy growth models
models of technological catch-up

Note: this convergence is not Solow-Swan

convergence to steady state
can consider country convergence in S-S model but
must assume technology common to all countries

Weighted world inter-country inequality (role of China and India)

0.600

World
0.560

Gini coefficient

World without
China
0.520

0.480
World without India and China

0.440

0.400

Summary (I)
Sigma () convergence
Using unweighted measures, cross-country
evidence suggests divergence
Weighted measures convergence over
last 30 years due to performance of China
However, most recent world inequality
measures based on within and across
country data, divergence

Summary (II)
Beta () convergence
No unconditional convergence
There is conditional convergence (poorer
countries grow faster if you control for other
factors)
Expect this (basic closed economy Solow
and endogenous growth models predict this)

Endnotes
Inequality/Convergence
Gini coefficient, world income inequality.
The Gini coefficient varies from 0 (perfect equality) to
1 (perfect inequality).
The discussion related to this overlooks many
important and controversial issues. See Milanovic
(2002) for a discussion, or google it.
Milanovic, B. (2002). "Worlds Apart: Inter-National
and World Inequality 1950-2000". World Bank,
[Link]
.org/research/inequality/world%20income%20distribu
tion/world%20apart.
pdf.