Economics 314 Coursebook, 2008 Jeffrey Parker 5 THEORIES OF ENDOGENOUS GROWTH Chapter 5 Contents A. Topics and Tools ..................................................................................2 B. The Microeconomics of Innovation and Human Capital Investment4 Returns to research and development..................................................................4 Human capital vs. knowledge capital .................................................................6 Returns to education..........................................................................................7 C. Understanding Romer=s Chapter 3, Part A........................................10 Introduction....................................................................................................10 Romer’s modeling strategy and the research literature ......................................10 The basic setup of the R&D model ...................................................................11 The knowledge production function ..................................................................12 Analysis of the model without capital................................................................13 The R&D model with capital ..........................................................................17 Returns to scale and endogenous growth ...........................................................19 Scale effects in the R&D model........................................................................20 D. Understanding Romer’s Chapter 3, Part B .......................................22 The specification of the human-capital model....................................................22 Analysis with the human-capital model............................................................22 Output per person vs. output per worker ..........................................................24 The specification of Romer’s predation model ....................................................27 Agents’ decisions in the predation model ...........................................................28 E. Suggestions for Further Reading.......................................................31 General texts on modern growth theory............................................................31 Selected seminal papers in modern growth theory..............................................32 F. Works Cited in Text ...........................................................................325 — 2 A. Topics and Tools The neoclassical growth theory that we studied in Chapters 3 and 4 largely evolved in the 1950s. There was considerable filling-in of details in the 1960s, but by the 1970s growth theory had largely become moribund. A tremendous revitalization has occurred since the 1980s, spurred by several shortcomings of the previous theories. First, because growth rates are exogenous in the Solow and Ramsey models, these theories are unable to explain why growth rates (and, in particular, the rate of technological progress) change from one time period to another. This became an important topic of research in the 1980s when the emerging data began to convince macroeconomists that productivity growth had declined significantly beginning about 1974. The second failing of neoclassical growth theory is that it cannot explain the large and lasting differentials in per-capita income across countries and regions. Solow’s growth model implies more rapid convergence of incomes than seems actually to have occurred, particularly between developed and developing coun-tries. Another feature of neoclassical growth models that some economists and policymakers find troublesome is that they provide no mechanism by which the saving and investment rate (or government policies directed at influencing it) can affect the steady-state growth rate. While this conclusion of neoclassical models is not obviously counterfactual, many find it counterintuitive and have explored models in which saving plays a more central role. The pioneer of “endogenous growth theory” is Paul Romer, a former col-league but not a relative of our textbook author.1 His 1986 paper in the Journal of Political Economy is a seminal work in the modern revitalization of growth theory. The principal engine behind endogenous growth is the elimination of the as-sumption of diminishing marginal returns to capital.2 In order to justify this radi- 1In the early 1990s, there were three famous young Romers teaching macroeconomics at the Uni-versity of California at Berkeley. Paul, who focuses on growth theory and is now at the Stanford Business School, David (our author), who is a prominent neo-Keynesian, and David’s wife Chris-tina, who is a macroeconomic historian. 2Be sure that you distinguish carefully between diminishing marginal returns and the issue of in-creasing, constant, or decreasing returns to scale. The former refers to what happens as successive5 — 3 cal departure from a long-established assumption of microeconomic theory, Romer and his followers have broadened the definition of capital to include hu-man capital and/or knowledge capital. As we shall see, once this broader view of capital is adopted it is no longer obvious that there are diminishing marginal re-turns. This leads to radical changes in the conclusions that we derive from mod-els that are otherwise similar to those of Solow and Ramsey. There are three basic models developed in the chapter: the R&D model of 3.2 and 3.3, the human-capital model of 3.8, and the production-protection-predation model of section 3.11. We will give attention to all three. The mathematical tools used here are largely familiar ones. To keep the analysis simple, Romer reverts to the simple Solow assumptions about saving (and other static resource allocation decisions). The original literature on these models bases decisions on utility and profit maximization, which is more satisfac-tory, but the dynamic properties of the model are similar with constant growth rates, so you can learn the essential features of the model without all the compli-cated mathematics that we did in Romer’s Chapter 2.3 As in previous chapters, we will be searching for steady-state balanced growth paths. To find these, we will usually look for situations in which the growth rates of the key state variables are constant. In most of the models of this chapter, there will be two state variables, either physical capital and knowledge or physical capital