Lecture 6

THEORIES OF ECONOMIC GROWTH

By:

Amsalu B. (MSc. In Economics)

Lecturer, Department of Economics

Unity University

Email: amsalueco21@gmail.com

Unity, Ethiopia
 4.1. Defining Economic Growth

 Economic growth can be defined as the increase in the economy‟s

output over time.

 In other words, one can say that the economy has increased its physical
ability to produce more goods and services

 Graphically, economic growth can be shown by an outward shift of

production possibility frontier (PPF) for the economy.

 In the figure below production possibility frontier has shifted outward

signifying the increased productive capability of the economy.

 The economy can produce more of both capital and consumer

goods because of economic growth
 4.2. Determinants of Economics Growth
1. Human resource and its quality
 It is comprised of the available labor force and the level of its
education, training, and its invention and innovative abilities.
 It is the appropriate combination of labor with different skill and very
important in making optimum use of human resources.
2. Natural resources
 It includes the area of usable land (particularly arable land), and
resources on the land surface and underground.
 Land surface resources includes natural water, forest and so on
 Underground resources are oil, natural gas, and minerals

 Favorable climate and environments is also another element.

3. Capital formation
 Requires sparing men and material resources from their use in consumer goods an
transforming into capital goods.
 It means scarifying current consumption and saving incomes to be invested.
 In general the countries with a high rate of saving and investment have a higher rate o
economic growth.
4. Technology (technical progress)
 Refer to scientific method and technique of production.
 Means the amount of machinery and technical equipments used with a given amount o
labor.
5. Political environment
 It plays a very important role in creating conducive environment for economic growth.

 If a country is often facing war and political instability then large part o
resources will be wasted
 A sound Law and order, stable price, competitive markets and private
property helps investment and production.
 Other factors like international trade which can help in promoting growth of
less developed countries.
4.3. Theories of economic Growth
4.3.1. The Harrod–Domar Model
 Roy Harrod (1939, 1948) and Evsey Domar (1946, 1947) independently
developed theories that relate an economy‟s rate of growth to its capital
stock. We will only refer to the Harrod-Domar model not the separate one.
 It is one of the simplest growth theories, which extends the simple short run
Keynesian model into the long-run
 It is an extension of Keynesian short-term analysis of full employment and
income theory and provides “a more comprehensive long period theory of
output”
 While Keynes emphasized the impact of investment on aggregate demand,
Harrod and Domar emphasized how investment spending also increased an
economy‟s productive capacity (a supply-side-effect).
 A major strength of the Harrod–Domar model is its simplicity.
 The assumption of the model
A. The economy is closed and there is no government economic activity.
B. There are only two factors of production, labor (L) and capital (K), and in our
simple version of the model, there is no technical progress.
C. Labor is homogenous and exogenous, measured in its own units and grows at
the constant natural rate of growth.
D. The production exhibits constant returns to scale.
E. Saving (s) is a fixed proportion of income (Y) that is S = sY where s is both the
average and marginal propensity of save. Investment (I) is autonomous and
there is no depreciation.
F. The potential level of national income (Y) is proportional to the quantity of
capital and to quantity of labor. Thus, a given technology exhibits fixed
factor proportions (constant capital–labour ratio, K/L) and a fixed capital–
output ratio (K/Y).
 Then we can write the simple national income account as:
Yt = Ct + St
 Where Yt= GDP, Ct = consumption and St = saving. It = investment.
Equilibrium in this simple economy requires:
It= St
 Substitutions yields
Yt = Ct + It
 The growth of real GDP is assumed to be proportional to the share of
investment spending (I) in GDP and for the growth of an economy, net
additions to the capital stock are required.
 The accumulation of the capital stock over time is given in equation:
Kt+1 = (1-δ)Kt + It
 The relationship between the size of the total capital stock (K) and total GDP (Y) is
known as the capital–output ratio (K/Y = k) and is assumed to be fixed.
 It also follows that k = ∆K/∆Y (where ∆K/∆Y is the incremental capital–output ratio,
or ICOR).
 Assume that total new investment is determined by total savings. And the total
saving is some fraction (s) of GDP (Y).
St= sYt
 Since K = kYt and It = St, it follows that we can rewrite equation for
accumulation of the capital stock as:
kYt+1 = (1-δ)kYt + sYt
 Dividing through by k, simplifying, and subtracting Yt from both sides of
equation yields:
Yt+1 –Yt = [s/k-δ]Yt
 Dividing through by Yt gives us equation:
[Yt+1 –Yt]/Yt = (s/k)-δ
 Since [Yt+1 –Yt]/Yt is growth rate of GDP(G or ∆Y/Y), we can write the Harrod–
Domar growth equation as:
∆Y/Y= (s/k)-δ
 This simply states that the growth rate of GDP is jointly determined by the savings
ratio (s) divided by the capital–output ratio (k).
 The higher the savings ratio and the lower the capital–output ratio and depreciation
rate, the faster will an economy grow.
 We will ignore the depreciation rate and consider the Harrod–Domar model as being
represented by the equation:
∆Y/Y= s/k
 The model says that in the absence of government, the growth rate of national
income will be directly or positively related to the savings ratio
 i.e., the more an economy is able to save and invest out of a given GDP, the greater
the growth of that GDP will be

 And the growth rate of national income is inversely or negatively related to the
economy’s capital-output ratio (i.e., the higher k is, the lower the rate of GDP
growth will be)

 The economic logic of the model is for an economy to grow, it must save and invest
a certain proportion of their GDP.

 But the actual rate at which an Income can grow for any level of saving and
investment, how much additional output can be had from an additional unit of
investment, can be measured by the inverse of the capital-output ratio, k, because this
inverse, 1/k, is simply the output-capital or output-investment ratio.

 It measures productivity of investment.

Constraint to or obstacle to development

 According to Harrod-Domar growth model, one of the most fundamental strategies

of economic growth is simply to increase the proportion of national income saved
(i.e., not consumed).
 For example, if we assume that the national capital-output ratio in some less
developed country is, say, 3% and the aggregate net saving ratio is 6% of GDP, it
follows from the model that this country can grow at a rate of 2% per year because
G=∆Y/Y= s/k=6/3=2%
 Now if s can somehow be increased from 6% to 15%, through some combination of
increased taxes, foreign aid, and general consumption sacrifices, GDP growth can be
increased from 2% to 5%.
 The main obstacle to or constraint on development, according to this theory, is the
relatively low level of new capital formation in most poor countries.
 But if a country wanted to grow at, say, a rate of 7% per year
and if it could not generate savings and investment at a rate of
21% of national income (k=3%) and but could only manage to
save 15%, it could seek to fill this “savings gap” of 6% either
through private saving or foreign aid.
 If domestic sources of finance were inadequate to achieve the desired
growth target, then foreign aid could fill the „savings gap‟ . Aid
requirements (Ar) would simply be calculated as:

Ar =s* – s
 Weakness of Harrod–Domar model

1. A major weakness of the Harrod–Domar approach is the

assumption of a fixed capital–output ratio. The inverse of k (1/k)
is the productivity of investment. It is determined by the
efficiency of the policy framework and the incentive structures
within which investment decisions are taken.
2. The model also assumed that aid inflows would go into investment
one to one. But Aid does not go into investment one to one
. The Solow Neoclassical Growth Model

 The Solow growth model shows how saving, population growth, and
technological progress affect the level of an economy‟s output and its
growth over time.

 Assumptions

i. The economy consists of one sector producing one type of

commodity that can be used for either investment or consumption
purposes;

ii. The economy is closed and the government sector is ignored;

 iii. All output that is saved is invested;

iv. Since the model is concerned with the long run, the economy is always
producing its potential (natural) level of total output

v. Solow abandons the Harrod–Domar assumptions of a fixed capital–

output ratio (K/Y) and fixed capital–labour ratio (K/L);

vi. The rate of technological progress, population growth and the

depreciation of the capital stock are all determined exogenously.
 There
are three key relationships in the Solow model, namely, the
production function, the consumption function and the capital
accumulation process.
 The production function
 Themodel is built around the neoclassical aggregate production
function and focuses on the proximate causes of growth:
Y =At F (K, L)
 Sometimes, At is called „total factor productivity‟.

 In the neoclassical theory of growth, technology is assumed to be

a public good.

 Let us concentrate on the relationship between output per worker

and capital per worker. We can therefore rewrite as:

Y =F (K, L)
 Where Y is real output, K is capital, L is the labour input and At is a
measure of technology

 The aggregate production function given satisfies the following three

conditions.

 First, for all values of K > 0 and L > 0, the function exhibits positive
but diminishing marginal returns with respect to both capital and
labour; that is, ∂F/∂K > 0, ∂2F/∂K2 < 0, ∂F/∂L > 0, and ∂2F/∂L2 <
0.

 Second, the production function exhibits constant returns

to scale such that F (λK, λL) = λY; that is, raising inputs
by λ will also increase aggregate output by λ.
 Letting λ =1/L yields Y/L = F (K/L). Then the equation is
written down in intensive form as:

y=f(k), f‟(k) >0 and f”(k)<0

 Where y is output per worker (Y/L) and k= capital per worker

(K/L)
 The equation states that output per worker is a positive function
of the capital–labour ratio and exhibits diminishing returns
 Third, as (k→∞) the MPK →0; as the k→0 the MPK→∞.

 For a given technology, any country that increases its capital–

labour ratio (more equipment per worker) will have a higher
output per worker.
 However, because of diminishing returns, the impact on
output per worker resulting from capital accumulation per
worker (capital deepening) will continuously decline.
 Thus for a given increase in k, the impact on y will be much greater
where capital is relatively scarce than in economies where capital is
relatively abundant.

 The slope of the production function measures the marginal

product of capital, where MPK=f(k+1)-f(k).
Figure 1: The neoclassical aggregate production function

 In the Solow model the MPK should be much higher in developing countries
compared to developed countries
 The consumption function
 Since output per worker depends positively on capital per worker,
we need to understand how the capital–labour ratio evolves over
time.
 In a closed economy aggregate output = aggregate income and
comprises two components, namely, consumption (C) and
investment (I) = Savings (S). Therefore we can write equation for
income as:
Y= C+I or equivalently Y=C+S
 Here S =sY is a simple savings function where s is the fraction of
income saved and 1 > s > 0. We can rewrite as:
Y=C+ sY
 The capital accumulation process

A country‟s capital stock (Kt) at a point in time consists of

plant, machinery and infrastructure.

 Each year a proportion of the capital stock wears out.

 Countering this tendency for the capital stock to decline is a

flow of investment spending each year (It) that adds to the
capital stock
 Now we can write an equation for the evolution of the capital stock of the following
form:

Kt+1 =(1-δ)Kt+ It = Kt - δKt + sYt

 Rewriting the above equation in per worker terms yields equation:

Kt+1 /L=(sYt /L)+(Kt /L)- (δKt /L)

 Deducting Kt /L from both sides of the above equation gives us:

Kt+1 /L - Kt /L=(sYt /L)- (δKt /L)

 The fundamental differential equation of the Solow model

∆k=sf(k)- δk

 The steady-state condition in the Solow model is given as:

sf(k*) =δk*
 Thus, in the steady state sf(k*) =δk*; that is, investment per worker is just sufficient to
cover depreciation per worker, leaving capital per worker constant.
Figure 3 Investment, Depreciation and Steady- state
 How Saving Affects Growth

 The economy is assumed to begin in a steady state with saving rate s1and capital
stock k1*.

 When the saving rate increases from s1 to s2, the sf(k) curve shifts
upward.

 At the initial saving rate s1 and the initial capital stock k1*, the amount of investment
just offsets the amount of depreciation

 Immediately after the saving rate rises, investment is higher, but the capital stock and
depreciation are unchanged.

 Therefore, investment exceeds depreciation. The capital stock will gradually rise
until the economy reaches the new steady state k2*, which has a higher capital stock
and a higher level of output than the old steady state.
 The Solow model shows that the saving rate is a key determinant
of the steady-state capital stock.
 If the saving rate is high, the economy will have a large capital stock
and a high level of output in the steady state.

 If the saving rate is low, the economy will have a small capital stock
and a low level of output in the steady state.

A government budget deficit can reduce national saving and

crowd out investment. The long-run consequences of a reduced
saving rate are a lower capital stock and lower national income.
 According to Solow model higher saving leads to faster growth,
but only temporarily. An increase in the rate of saving raises
growth only until the economy reaches the new steady state.

 If the economy maintains a high saving rate, it will maintain a

large capital stock and a high level of output, but it will not
maintain a high rate of growth forever.

 Policies that alter the steady-state growth rate of income per

person (y) are said to have a growth effect.

 By contrast, a higher saving rate is said to have a level effect,

because only the level of income per person influenced by the
saving rate in the steady state.
 Comparing Steady States
 By setting a saving rate, a policymaker determines the economy‟s steady
state. What steady state should the policymaker choose?
 The policymaker‟s goal is to maximize the well-being of individual who
make up a society.
 Individuals care about the amount of goods and services they can consume.
 Thus, a benevolent policymaker would want to choose the steady-state with
the highest level of consumption.
 The steady-state value of k that maximizes consumption is called the Golden
Rule level of capital and is denoted k*Gold.
 To identify whether an economy is at the Golden Rule level, we must first
determine steady-state consumption per worker. Then we can see which
steady-state provides the most consumption.
 Lets begin with the national income accounts identity

c=y-i

 Steady-state output per worker is f(k*), where k* is the steady-

state capital stock per worker. Furthermore, because the capital
stock is not changing in the steady state, investment equals
depreciation δk*

 We can write steady-state consumption per worker as

c=f(k*)- δk*

 Accordingly, steady-state consumption is what‟s left of steady-

state output after paying for steady-state depreciation
 This equation shows that an increase in steady-state capital has
two opposing effects on steady-state consumption
 On the one hand, more capital means more output
 On the other hand, more capital also means that more output must
be used to replace capital that is wearing out.

 Steady-state consumption is the gap between output and

depreciation.

 This figure shows that there is one level of the capital stock, the
Golden Rule level that maximizes consumption
 If the capital stock is below the Golden Rule level, an
increase in the capital stock raises output more than
depreciation, so consumption rises.
  The production function is steeper than the depreciation line, so

the gap between these two curves, which equals consumption,

grows as k* rises

 By contrast, if the capital stock is above the Golden Rule level, an

increase in the capital stock reduces consumption, because the

increase in output is smaller than the increase in depreciation.

 The production function is flatter than the line, so the gap

between the curves, consumption, shrinks as k* rises

  At the Golden Rule level of capital, the production function

and the depreciation line have the same slope, and

consumption is at its greatest level.

A simple condition that characterizes the Golden Rule level of

capital.

 The slope of the production function is the marginal product of capital

MPK and the slope of the δk* line is δ. These two slopes are

equal at k*Gold.

 The Golden Rule is described by the equation MPK = δ.

 The net effect of the extra unit of capital on consumption is MPK – δ.
If MPK – δ > 0, then increases in capital increase consumption, so k*
must be below the Golden Rule level.

 If MPK – δ < 0, then increases in capital decrease consumption, so k*

must be above the Golden Rule level.

 Therefore, the following condition describes the Golden Rule:

MPK – δ=0

 Keep in mind that the economy does not automatically gravitate

toward the Golden Rule steady-state. If we want any particular steady-
state capital stock, such as the Golden Rule, we need a particular
saving rate to support it.
 If the saving rate is higher than the one used in this figure, the steady-
state capital stock will be too high. If the saving rate is lower, the
steady-state capital stock will be too low.

 In either case, steady-state consumption will be lower than it is at the

Golden Rule steady state.
 Figure 5: The Saving Rate and the Golden Rule
 Population growth and steady-state capital accumulation
 Extending the model to allow for growth of the labour force is
relatively straightforward.
 In the Solow model it is assumed that the labor force participation rate
is constant, so that the labour force grows at a constant proportionate
rate equal to the exogenously determined rate of growth of population
=n
 Since k=K/L, population growth, by increasing the supply of labour,
will reduce k.
 Therefore population growth has the same impact on k as depreciation.
The fundamental differential equation now becomes:

∆k=sf(k)- (n+δ)k
 In order to prevent k from falling, some investment (δk) is required to
offset depreciation
 Some investment (nk) is also required because the quantity of labour is
growing at a rate = n.
 Hence the capital stock must grow at rate (n + δ) just to hold k steady.
 When investment per unit of labour is greater than required for break-
even investment, then k will be rising and in this case the economy is
experiencing „capital deepening‟.

 Given the structure of the Solow model the economy will

approach a steady state where Actual investment per
worker, sf(k), equals break-even investment per worker
(n + δ)k.
 Using * to indicate steady-state values, we can define the
steady state as: sf(k *)= (n + δ)k*
 At the capital–labour ratio k1 , savings (investment) per worker
(point b) exceed required investment (point c) and so the
economy experiences capital deepening and k rises.

 At k2, because the capital–labour ratio falls, capital becomes

„shallower‟

 The steady state balanced growth path occurs at k*, where

investment per worker equals break-even investment. Output per
worker is y* and consumption per worker is e – a

 The bottom panel of Figure 4 shows the relationship between ∆k

(the change of the capital–labour ratio) and k with a phase
diagram. When ∆k > 0, k is rising; when ∆k < 0, k is falling.
 The Effects of Population Growth

 Population growth alters the basic Solow model in three ways.

 First, it brings us closer to explaining sustained economic growth.

 In the steady state with population growth, capital per worker and
output per worker are constant.

 Since the number of workers is growing at rate n, however, total

capital and total output must also be growing at rate n.

 Hence, although population growth cannot explain sustained growth in

the standard of living (because output per worker is constant in the
steady state), it can help explain sustained growth in total output.
 Second, population growth gives us another explanation for why
some countries are rich and others are poor.
 Consider the effects of an increase in population growth.
 An increase in the rate of population growth reduces the steady-
state level of capital per worker.
 Because k* is lower and because y* = f(k*), the level of output
per worker y* is also lower.
 Thus, the Solow model predicts that countries with higher
population growth will have lower levels of GDP per person.
 Finally, population growth affects our criterion for determining
the Golden Rule (consumption-maximizing) level of capital.
 To see how this criterion changes, note that consumption per worker is
c=y-i

 Because steady-state output is f(k*) and steady-state investment is (n

+ δ)k* , we can express steady-state consumption as
c* =f(k*) − (δ + n)k*.
 We conclude that the level of k* that maximizes consumption is the
one at which
MPK = δ + n,
Or equivalently
MPK– δ = n.
 In the Golden Rule steady state, the marginal product of capital net of
depreciation equals the rate of population growth.
 Figure 7 the impact of population growth
 Technological Progress and Solow Model

 So far, Solow model has assumed that the production function is

not changing.

 Now let us assume that technological progress is exogenous

which over time expands society‟s ability to produce.

 To incorporate technological progress, let us take the production

function which relates total capital K and total labor L to total
output Y. Y=F(K,L)
 We now write the production function as
Y= f(K, LxE)
 Where, E is called the efficiency of labor. This is due to the fact that
as the available technology improves the efficiency of labor increases.
 The term L × E measures the number of effective workers.
 This new production function states that total output Y depends on the
number of units of capital K and on the number of effective workers L
× E.
 Increases in the efficiency of labor E are, in effect, like increases in the
labor force L.
 The simplest assumption about technological progress is that it causes
the efficiency of labor E to grow at some constant rate „g’ called the
rate of labor augmenting technological progress.
 Because the labor force L is growing at rate „n’, and the
efficiency of each unit of labor E is growing at rate „g’, and
the number of effective workers L × E is growing at rate n +
g.
 Now we are analyzing the economy in terms of output per
effective worker and allow the number of effective workers to
rise.
 In order to do this, we have to modify our notation slightly.
 k=K/LxE stand for capital per effective labour and
 y=Y/LxE stands for output per effective labour
 Then we can write with some modification y=f(k)
 The equation showing the evolution of k over time now changes to

∆k=sf(k)- (n+δ+g)k or

∆k=sy- (n+δ+g)k
 As before, the change in the capital stock k equals investment minus
depreciation along with population growth and efficiency rate.

 The only difference is that k=K/LxE, thus depreciation line includes

three terms

 „δk‟ is needed to replace depreciating capital, ‘nk’ is needed to

provide capital for new workers, and „gk‟ is needed to provide
capital for the new “effective workers” created by technological
progress.
Figure 8 Technological Progresses and the Solow Growth Model
 Now that k is defined as the amount of capital per effective worker,

increase in the number of effective workers, because technological

progress, tends to decrease k.

 We have seen already seen three cases in Solow model i.e. with capital

accumulation, with population growth and with technological progress.

The key concepts of Solow model are as follows.

A. The growth rate of output in steady state is exogenous and

independent of savings rate.

B. Although an increase in the savings rate does not affect the steady

state growth rate, it does increase the steady state level of income

by increasing the capital labour ratio.

 Now that k is defined as the amount of capital per effective worker,
increase in the number of effective workers, because technological
progress, tends to decrease k.

 We have seen already seen three cases in Solow model i.e. with capital
accumulation, with population growth and with technological progress.
The key concepts of Solow model are as follows.

A. The growth rate of output in steady state is exogenous and

independent of savings rate.

B. Although an increase in the savings rate does not affect the steady
state growth rate, it does increase the steady state level of income by
increasing the capital labour ratio.
 Beyond the Solow Model: Endogenous Growth Theory
 One goal of growth theory is to explain the persistent rise in living
standards that we observe in most parts of the world.
 The Solow growth model shows that such persistent growth must
come from technological progress. But where does technological
progress come from? In the Solow model, it is just assumed!
 the productivity slowdown of the 1970s and speed-up of the 1990s
suggests that changes in the pace of technological progress are
tremendously important.
 Models that explain technological advance often go by the label
endogenous growth theory because they reject the Solow model‟s
assumption of exogenous technological change
 The Basic Model

 To illustrate the idea behind endogenous growth theory, let‟s start

with a particularly simple production function:

Y = AK

 where Y is output, K is the capital stock, and A is a constant measuring

the amount of output produced for each unit of capital.

 Notice that this production function does not exhibit the property
of diminishing returns to capital.

 One extra unit of capital produces A extra units of output,

regardless of how much capital there is.
 As before, we assume a fraction of income is saved and invested.
We therefore describe capital accumulation with an equation
similar to those we used previously:

∆K = sY- δK

 Combining this equation with the production function, we

obtain, after a bit of manipulation,

∆Y/Y = ∆K/K = sA- δ

Notice that, as long as sA –δ is positive, the economy‟s income

grows forever, even without the assumption of exogenous
technological progress.
 In the Solow model, saving leads to growth temporarily, but
diminishing returns to capital eventually force the economy to
approach a steady state in which growth depends only on exogenous
technological progress
 By contrast, in this endogenous growth model, saving and investment
can lead to persistent growth.
 But is it reasonable to abandon the assumption of diminishing returns
to capital? The answer depends on how we interpret the variable K in
the production function Y = AK.
 If we take the traditional view that K includes only the economy‟s
stock of plants and equipment, then it is natural to assume diminishing
returns.
 Advocates of endogenous growth theory, however, argue that the
assumption of constant returns to capital is more palatable if K is
interpreted more broadly

 The model views knowledge as a type of capital. Clearly,

knowledge is an important input into the economy‟s production,
both its production of goods and services and its production of
new knowledge.

 If we accept the view that knowledge is a type of capital, then

this endogenous growth model with its assumption of constant
returns to capital becomes a more plausible description of long-
run economic growth.
 A Two-Sector Model
 The economy has two sectors, which we can call manufacturing firms
and research universities.
 Firms produce goods and services, which are used for consumption
and investment in physical capital.
 Universities produce a factor of production called “knowledge,” which
is then freely used in both sectors. The economy is described by the
production function for firms, the production function for universities,
and the capital-accumulation equation:

 Y = F[K,(1-u)LE] (Production function in manufacturing firms),

 ∆E = g(u)E (production function in research universities),

 ∆K = sY – δK (capital accumulation),
 where u is the fraction of the labor force in universities (and 1 – u is

the fraction in manufacturing), E is the stock of knowledge (which in

turn determines the efficiency of labor), and is a function that shows

how the growth in knowledge depends on the fraction of the labor

force in universities. The rest of the notation is standard.

 As usual, the production function for the manufacturing firms is

assumed to have constant returns to scale:

 If we double both the amount of physical capital (K) and the effective

number of workers in manufacturing (1-μ)LE, we double the output of good

and service(Y ).
 The relationship between this model and the Y = AK model.
 The economy exhibits constant (rather than diminishing) returns to
capital, as long as capital is broadly defined to include knowledge.

 In particular, if we double both physical capital K and knowledge E,

then we double the output of both sectors in the economy.

 As a result, like the Y = AK model, this model can generate

persistent growth without the assumption of exogenous shifts in the
production function. Here persistent growth arises endogenously
because the creation of knowledge in universities never slows down.
 At the same time, however, this model is also a cousin of the Solow
growth model.

 If uis held constant, then the efficiency of labor E grows at the

constant rate g(μ). This result of constant growth in the efficiency of
labor at rate g is precisely the assumption made in the Solow model
with technological progress

 Moreover, the manufacturing productions function and the capital-

accumulation equation, also resembles the rest of the Solow model. As
a result, for any given value of u, this endogenous growth model
works just like the Solow model.
The Microeconomics of Research and Development

 The two-sector endogenous growth model just presented still tells only
a rudimentary story about the creation of knowledge.

 Three facts about the process of research and development

 First, although knowledge is largely a public good (that is, a good
freely available to everyone), much research is done in firms that are
driven by the profit motive.

 Second, research is profitable because innovations give firms

temporary monopolies

 Third, when one firm innovates, other firms build on that innovation to
produce the next generation of innovations
 These, essentially microeconomic, facts are not easily connected with
the (essentially macroeconomic) growth models we have discussed so
far.

 Some endogenous growth models try to incorporate these facts about

research and development

 One question these models are designed to address is whether, from the
standpoint of society as a whole, private profit-maximizing firms tend
to engage in too little or too much research.

 In other words, is the social return to research (which is what society

cares about) greater or smaller than the private return (which is what
motivates individual firms)
 It turns out that, as a theoretical matter, there are effects in both
directions

 On the one hand, when a firm creates a new technology, it makes other
firms better off by giving them a base of knowledge on which to build
in future research. These positive externality is called “standing on the
shoulder”

 On the other hand, when one firm invests in research, it can also make
other firms worse off if it does little more than being the first to
discover a technology that another firm would have invented in due
course. This negative externality is “stepping on Toes”
 Whether firms left to their own devices do too little or too much
research depends on whether the positive “standing on
shoulders” externality or the negative “stepping on toes”
externality is more prevalent.

 Many studies have suggested the “standing on shoulders”

externality is important and, as a result, the social return to
research is large, often in excess of 40 percent per year

 This finding justifies substantial government subsidies to

research.
 The Process of Creative Destruction
 An economist Joseph Schumpeter suggested that economic progress
comes through a process of “creative destruction.”
 Accordingly, the driving force behind progress is the entrepreneur
with an idea for a new product, a new way to produce an old product,
or some other innovation.

 When the entrepreneur‟s firm enters the market, it has some

degree of monopoly power over its innovation; indeed, it is the
prospect of monopoly profits that motivates the entrepreneur.
 The entry of the new firm is good for consumers, who now have
an expanded range of choices, but it is often bad for incumbent
producers, who may find it hard to compete with the entrant.
 If the new product is sufficiently better than old ones, the incumbents
may even be driven out of business. Over time, the process keeps
renewing itself.

 The entrepreneur‟s firm becomes an incumbent, enjoying high

profitability until its product is displaced by another entrepreneur with
the next generation of innovation.

 For example, in England in the early nineteenth century, an important

innovation was the invention and spread of machines that could
produce textiles using unskilled workers at low cost.

 This technological advance was good for consumers, who could clothe
themselves more cheaply.
 Yet skilled knitters in England saw their jobs threatened by new
technology, and they responded by organizing violent revolts.

 The rioting workers, called Luddites, smashed the weaving

machines used in the wool and cotton mills and set the homes of
the mill owners on fire (a less than creative form of destruction).
 Today, the term “Luddite” refers to anyone who opposes
technological progress.

 Faced with the prospect of being the victims of creative

destruction, incumbent producers often look to the political
process to stop the entry of new, more efficient competitors.

 The original Luddites wanted the British government to save

their jobs by restricting the spread of the new textile technology;
instead, Parliament sent troops to suppress the Luddite riots
 Example
Assume that the Cobb-Douglas production function is given as
Y = K1/2L1/2 .And assume that 30 percent of national output
is saved, that 10 percent of the capital stock depreciates
every year, and that the economy starts off with 4 units of
capital per worker (k =4). Then examine what to the
economy
A. Drive derive the per-worker production function f(k)

B. What the value of y(output per worker) given k=4

C. What are the values of investment and consumption per

worker.
D. What is the value of depreciation?

E. What are the steady state values of k, y, c and i?

F. Assume population grows at 3% each year. Then what is

the steady state capital per worker?
G. What are the values of k and y if the economy operates at
the “Golden Rule” level of capital accumulation?
THAKS!!!

END!!!

THAKS!!! 72