The Romer Model

Martin Ellison, Hilary Term 2017

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Introduction

The Romer model

• Focusses on the distinction between ideas and objects
• Stipulates that output requires knowledge and labour
The production function of the Romer model
• Constant returns to scale in objects alone
• Increasing returns to scale in objects and ideas
New ideas depend on
• The existence of ideas in the previous period
• The number of workers producing ideas
• Worker productivity
Unregulated markets traditionally do not provide enough resources to produce ideas
• Hence they are underprovided
The population
• Workers producing ideas and workers producing output
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Labour in the Romer model

Labour
• 𝐿𝐿𝑦𝑦𝑦𝑦 workers producing output
• 𝐿𝐿𝑎𝑎𝑡𝑡 workers producing ideas
• is an object so subject to a resource constraint 𝐿𝐿𝑦𝑦𝑦𝑦 + 𝐿𝐿𝑎𝑎𝑡𝑡 = 𝐿𝐿�

Allocation of labour
• proportion 1 − 𝑙𝑙 ̅ of workers produce output
• proportion 𝑙𝑙 ̅ of workers produce ideas

Endogenous 𝐿𝐿𝑦𝑦𝑦𝑦 = (1 − 𝑙𝑙)̅ 𝐿𝐿�

variables
𝐿𝐿𝑎𝑎𝑡𝑡 = 𝑙𝑙 ̅ 𝐿𝐿� Parameters 𝑙𝑙,̅ 𝐿𝐿�

• decided by markets in original Romer model, with patents and monopoly power
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Production in the Romer model

Output
• Produced using stock of existing knowledge 𝐴𝐴𝑡𝑡 and workers 𝐿𝐿𝑦𝑦𝑡𝑡
𝑌𝑌𝑡𝑡 = 𝐴𝐴𝑡𝑡 𝐿𝐿𝑦𝑦𝑦𝑦
• Constant returns to objects
• Increasing returns to objects and ideas
Ideas
• Produced using stock of existing knowledge 𝐴𝐴𝑡𝑡 and workers 𝐿𝐿𝑎𝑎𝑡𝑡
Δ𝐴𝐴𝑡𝑡+1 = 𝑧𝑧𝐴𝐴
̅ 𝑡𝑡 𝐿𝐿𝑎𝑎𝑎𝑎
• 𝑧𝑧̅ is a productivity parameter for workers producing ideas
Standing on the shoulders of giants – Isaac Newton*
Stock of knowledge 𝐴𝐴𝑡𝑡 appears in both production of output and ideas - due to non-rivalry

* Quoting Bernard de Chartres - nanos gigantum humeris insidentes

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Summary of the Romer model

Unknowns / endogenous variables: 𝑌𝑌𝑡𝑡 , 𝐴𝐴𝑡𝑡 , 𝐿𝐿𝑦𝑦𝑦𝑦 , 𝐿𝐿𝑎𝑎𝑎𝑎 , parameters 𝑧𝑧,̅ 𝐿𝐿� , 𝑙𝑙,̅ 𝐴𝐴0

Relationship
Output production function
Idea production function
Resource constraint
Allocation of labour
Equation
𝑌𝑌𝑡𝑡 = 𝐴𝐴𝑡𝑡 𝐿𝐿𝑦𝑦𝑦𝑦
Δ𝐴𝐴𝑡𝑡+1 = 𝑧𝑧𝐴𝐴 ̅ 𝑡𝑡 𝐿𝐿𝑎𝑎𝑎𝑎
𝐿𝐿𝑦𝑦𝑦𝑦 + 𝐿𝐿𝑎𝑎𝑡𝑡 = 𝐿𝐿�
𝐿𝐿𝑎𝑎𝑡𝑡 = 𝑙𝑙 ̅ 𝐿𝐿�

Differences between Romer and Solow models:

• Added production of ideas
• Left out capital
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Solving the Romer model

Output per person depends on the total stock of knowledge*

𝑌𝑌𝑡𝑡 𝐴𝐴𝑡𝑡 𝐿𝐿𝑦𝑦𝑦𝑦

𝑦𝑦𝑡𝑡 ≡ = = 𝐴𝐴𝑡𝑡 (1 − 𝑙𝑙)̅
𝐿𝐿� 𝐿𝐿�
The growth rate of knowledge is constant

∆𝐴𝐴𝑡𝑡+1
Growth rate of ̅ 𝑎𝑎𝑡𝑡 = 𝑧𝑧̅ 𝑙𝑙 ̅ 𝐿𝐿�
= 𝑧𝑧𝐿𝐿
knowledge 𝐴𝐴𝑡𝑡
All constants

The stock of knowledge depends on its initial value and its growth rate

𝐴𝐴𝑡𝑡 = 𝐴𝐴̅0 (1 + 𝑔𝑔)̅ 𝑡𝑡 𝑔𝑔̅ ≡ 𝑧𝑧̅ 𝑙𝑙 ̅ 𝐿𝐿�

Stock of Initial amount of Growth rate of
knowledge knowledge knowledge

* Compare this to the Solow model, where output per person depends on capital per person
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Growth in output per person

Output per person grows at a constant rate and is a

straight line on a ratio scale

𝑌𝑌𝑡𝑡
Combine 𝑦𝑦𝑡𝑡 ≡ = 𝐴𝐴𝑡𝑡 (1 − 𝑙𝑙)̅ and 𝐴𝐴𝑡𝑡 = 𝐴𝐴̅0 (1 + 𝑔𝑔)̅ 𝑡𝑡
𝐿𝐿�

̅
𝑦𝑦𝑡𝑡 = 𝐴𝐴̅0 (1 − 𝑙𝑙)(1 + 𝑔𝑔)̅ 𝑡𝑡

The level of output per person is now written

entirely as a function of the parameters of the model
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Why is there growth in the Romer model?

The model produces the desired long-run growth that Solow did not
• In the Solow model, capital has diminishing returns so capital and income stop growing
The model does not have diminishing returns to ideas because they are non-rivalrous
Δ𝐴𝐴𝑡𝑡+1 = 𝑧𝑧𝐴𝐴
̅ 𝑡𝑡 𝐿𝐿𝑎𝑎𝑎𝑎
Look at the exponents on the endogenous terms on the right hand side
• Labour and ideas have increasing returns together
• Returns to ideas are unrestricted
Balanced growth
• The Romer model does not exhibit tranisition dynamics
• Instead, has balanced growth path
• The growth rate of all endogenous variables are constant at 𝑔𝑔̅ = 𝑧𝑧̅ 𝑙𝑙 ̅ 𝐿𝐿�
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Experiments in the Romer model – an increase in 𝐿𝐿�

An increase in population changes the

growth rate of knowledge

̅
𝑦𝑦𝑡𝑡 = 𝐴𝐴̅0 (1 − 𝑙𝑙)(1 + 𝑔𝑔)̅ 𝑡𝑡

𝑔𝑔̅ = 𝑧𝑧̅ 𝑙𝑙 ̅ 𝐿𝐿�

An increase in population will

immediately and permanently raise the
growth rate of per capita output
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Experiments in the Romer model – an increase in 𝑙𝑙 ̅

An increase in the fraction of labour producing

ideas, holding all other parameters equal, will
increase the growth rate of knowledge

̅
𝑦𝑦𝑡𝑡 = 𝐴𝐴̅0 (1 − 𝑙𝑙)(1 + 𝑔𝑔)̅ 𝑡𝑡

𝑔𝑔̅ = 𝑧𝑧̅ 𝑙𝑙 ̅ 𝐿𝐿�

If more people work to produce ideas, less people

produce output
• The level of output jumps down initially
• But the growth rate has increased for all
future years so output per person will be
higher in the long run
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Growth versus level effects

Growth effects are changes to the rate of growth of per capita output
Level effects are changes to the level of per capital output
The exponent on ideas in the production function determines the returns to ideas alone
If the exponent on ideas is not equal to 1
• The Romer model will still generate sustained growth
• Growth effects are eliminated if the exponent on ideas is less than 1, due to diminishing returns
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Combining Solow and Romer

The combined model adds capital into the Romer model production function
• The production function has constant returns to scale in objects but increasing returns in
1/3 2/3
ideas and objects together 𝑌𝑌𝑡𝑡 = 𝐴𝐴𝑡𝑡 𝐾𝐾𝑡𝑡 𝐿𝐿𝑦𝑦𝑡𝑡

• The change in the capital stock is investment minus depreciation ∆𝐾𝐾𝑡𝑡+1 = 𝑠𝑠𝑌𝑌 ̅ 𝑡𝑡
̅ 𝑡𝑡 − 𝑑𝑑𝐾𝐾
• Researchers are used to produce new ideas Δ𝐴𝐴𝑡𝑡+1 = 𝑧𝑧𝐴𝐴
̅ 𝑡𝑡 𝐿𝐿𝑎𝑎𝑎𝑎
• The number of workers and researchers sum to equal the total population 𝐿𝐿𝑦𝑦𝑦𝑦 + 𝐿𝐿𝑎𝑎𝑎𝑎 = 𝐿𝐿�

• A constant fraction of the population is assumed to work as researchers 𝐿𝐿𝑎𝑎𝑎𝑎 = 𝑙𝑙 ̅ 𝐿𝐿�

Combining the insights from Solow and Romer leads to a rich theory of economic growth
• The growth of world knowledge explains the underlying upward trend in incomes
• Countries may grow faster or slower than this world trend because of transition dynamics
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Summary of the combined Solow-Romer model

Unknowns / endogenous variables: 𝑌𝑌𝑡𝑡 , 𝐾𝐾𝑡𝑡 , 𝐴𝐴𝑡𝑡 , 𝐿𝐿𝑦𝑦𝑦𝑦 , 𝐿𝐿𝑎𝑎𝑎𝑎 , parameters 𝑠𝑠,̅ 𝑑𝑑,̅ 𝐿𝐿� , 𝑙𝑙,̅ 𝐴𝐴0 , 𝐾𝐾0

Relationship Equation
Output production function 1/3 2/3
𝑌𝑌𝑡𝑡 = 𝐴𝐴𝑡𝑡 𝐾𝐾𝑡𝑡 𝐿𝐿𝑦𝑦𝑡𝑡
Capital accumulation ∆𝐾𝐾𝑡𝑡+1 = 𝑠𝑠𝑌𝑌 ̅ 𝑡𝑡
̅ 𝑡𝑡 − 𝑑𝑑𝐾𝐾
Idea production function Δ𝐴𝐴𝑡𝑡+1 = 𝑧𝑧𝐴𝐴 ̅ 𝑡𝑡 𝐿𝐿𝑎𝑎𝑎𝑎
Resource constraint 𝐿𝐿𝑦𝑦𝑦𝑦 + 𝐿𝐿𝑎𝑎𝑡𝑡 = 𝐿𝐿�
Allocation of labour 𝐿𝐿𝑎𝑎𝑡𝑡 = 𝑙𝑙 ̅ 𝐿𝐿�

The combined model will result in

• a balanced growth path - since 𝐴𝐴𝑡𝑡 increases continually over time
• transition dynamics - due to capital accumulation
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Solving the combined model

1/3 2/3
Start from the output production function 𝑌𝑌𝑡𝑡 = 𝐴𝐴𝑡𝑡 𝐾𝐾𝑡𝑡 𝐿𝐿𝑦𝑦𝑦𝑦

Apply logarithms and differentiate to give growth rates

∆𝑌𝑌𝑡𝑡+1 1 2
𝑔𝑔𝑦𝑦𝑡𝑡 ≡ = 𝑔𝑔𝐴𝐴𝑡𝑡 + 𝑔𝑔𝐾𝐾𝑡𝑡 + 𝑔𝑔𝐿𝐿𝐿𝐿𝑡𝑡
𝑌𝑌𝑡𝑡 3 3

Growth rate of knowledge Growth rate of labour in output production

Divide production function for The number of workers in output
ideas by 𝐴𝐴𝑡𝑡 production is a constant fraction of the
constant population
∆𝐴𝐴𝑡𝑡+1 𝑔𝑔𝐿𝐿𝐿𝐿𝑡𝑡 = 0
𝑔𝑔𝐴𝐴𝑡𝑡 ≡ ̅ 𝑎𝑎𝑎𝑎 = 𝑧𝑧̅ 𝑙𝑙 ̅ 𝐿𝐿�
= 𝑧𝑧𝐿𝐿
𝐴𝐴𝑡𝑡
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Growth rate of capital along the balanced growth path

Divide capital accumulation equation by 𝐾𝐾𝑡𝑡

Constant along a balanced growth path

∆𝐾𝐾𝑡𝑡+1 𝑌𝑌𝑡𝑡 �
𝑔𝑔𝐾𝐾𝐾𝐾 ≡ �
= 𝑠𝑠 − 𝑑𝑑
𝐾𝐾𝑡𝑡 𝐾𝐾𝑡𝑡

𝑌𝑌𝑡𝑡
If growth is constant then ratio must be constant as well, therefore
𝐾𝐾𝑡𝑡

𝑌𝑌𝑡𝑡 1 𝑑𝑑 𝑌𝑌𝑡𝑡 1 𝑑𝑑 𝐾𝐾𝑡𝑡

= 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 log 𝑌𝑌𝑡𝑡 − log(𝐾𝐾𝑡𝑡 ) = log(𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐) − =0
𝐾𝐾𝑡𝑡 𝑌𝑌𝑡𝑡 𝑑𝑑𝑑𝑑 𝐾𝐾𝑡𝑡 𝑑𝑑𝑑𝑑

∗ ∗
Capital and output grow at the same rate* 𝑔𝑔𝐾𝐾 = 𝑔𝑔𝑌𝑌

* The asterisk means these variables are evaluated along a balanced growth path
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Growth rate of output

Put it all together

1 2 𝑔𝑔𝐴𝐴𝐴𝐴 = 𝑧𝑧̅ 𝑙𝑙 ̅ 𝐿𝐿� ≡ 𝑔𝑔̅ 1 ∗

𝑔𝑔𝑦𝑦𝑡𝑡 = 𝑔𝑔𝐴𝐴𝑡𝑡 + 𝑔𝑔𝐾𝐾𝑡𝑡 + 𝑔𝑔𝐿𝐿𝐿𝐿𝑡𝑡 𝑔𝑔𝐾𝐾∗ = 𝑔𝑔𝑌𝑌∗ 𝑔𝑔𝑌𝑌∗ = 𝑔𝑔̅ + 𝑔𝑔𝑌𝑌
3 3 3
𝑔𝑔𝐿𝐿𝐿𝐿𝐿𝐿 = 0

3 3
Solve for the growth rate of output 𝑔𝑔𝑌𝑌∗ = 𝑔𝑔̅ = 𝑧𝑧̅ 𝑙𝑙 ̅ 𝐿𝐿�
2 2
For the long-run combined model, this equation pins down the growth rate of output and the growth
rate of output per person
The growth rate of output is even larger in the combined model than in the Romer model
• Output is higher in this model because ideas have a direct and indirect effect
• Increasing productivity raises output because productivity has increased and higher productivity
results in a higher capital stock
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Output per capita

The equation for the capital stock can be solved for the capital-output ratio along a balanced growth path

∆𝐾𝐾𝑡𝑡+1 𝑌𝑌𝑡𝑡 𝑌𝑌 ∗
𝑡𝑡 𝑌𝑌𝑡𝑡∗ 𝑔𝑔𝑌𝑌∗ + 𝑑𝑑̅ 𝐾𝐾𝑡𝑡∗ 𝑠𝑠̅
= 𝑠𝑠̅ − 𝑑𝑑̅ 𝑔𝑔𝐾𝐾∗ = 𝑔𝑔𝑌𝑌∗ = 𝑠𝑠̅ ∗ − 𝑑𝑑̅ = =
𝐾𝐾𝑡𝑡 𝐾𝐾𝑡𝑡 𝐾𝐾𝑡𝑡 𝐾𝐾𝑡𝑡∗ 𝑠𝑠̅ 𝑌𝑌𝑡𝑡∗ 𝑔𝑔𝑌𝑌∗ + 𝑑𝑑̅

Substitute back into the production function for output and solve
1/2
1/3
𝐿𝐿∗𝑦𝑦𝑦𝑦
2/3 1/3 𝑠𝑠̅
𝑌𝑌𝑡𝑡∗ 𝐾𝐾𝑡𝑡∗ ̅ 𝑡𝑡∗
𝑠𝑠𝑦𝑦 2/3 𝑦𝑦𝑡𝑡∗ = ∗
∗3/2
𝐴𝐴𝑡𝑡 1 − 𝑙𝑙 ̅
𝑦𝑦𝑡𝑡∗ ≡ = 𝐴𝐴∗𝑡𝑡 = 𝐴𝐴∗𝑡𝑡 1 − 𝑙𝑙 ̅ 𝑔𝑔𝑌𝑌 + 𝑑𝑑̅
𝐿𝐿� 𝐿𝐿� 𝐿𝐿� 𝑔𝑔𝑌𝑌∗ + 𝑑𝑑̅

• Growth in 𝐴𝐴𝑡𝑡 leads to sustained growth in output per person along a balanced growth path
• Output per capita 𝑦𝑦𝑡𝑡 depends on the square root of the investment rate
• A higher investment rate raises the level of output per person along the balanced growth path
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Transition dynamics

The Solow model and combined model both have diminishing returns to capital
• transition dynamics applies in both models
The principle of transition dynamics for the combined model
• The father below its balanced growth path an economy is, the faster it will grow
• The father above its balanced growth path an economy is, the slower it will grow
A permanent increase in the investment rate in the combined model:
• The balanced growth path is higher (parallel shift)
• Current income is unchanged – the economy is now below the new balanced growth path
• The growth rate of income per capita is immediately higher – the slope of the output path is
steeper than the balanced growth path
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Experiments in the combined model – an increase in 𝑠𝑠̅
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