Journal of Economic Growth, 3: 111–130 (June 1998)

°
c 1998 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.

Capital Accumulation and Innovation as

Complementary Factors in Long-Run Growth

PETER HOWITT
The Ohio State University, Department of Economics, 410 Arps Hall, 1945 North High Street, Columbus, OH
43210-1172 USA

PHILIPPE AGHION
University College, London and EBRD, Department of Economics, Gower Street, London WC1E 6BT, United
Kingdom

We study capital accumulation and innovation as determinants of long-run growth by adding capital to our earlier
model of creative destruction. No special functional forms are imposed on the aggregate production function.
The equations describing perfect foresight equilibrium are identical to those of the augmented Ramsey-Cass-
Koopmans model, except that the rate of technological change is a function of the stock of capital per effective
worker. Contrary to previous models, a subsidy to capital accumulation will raise the long-run growth rate. The
key assumption is that capital is used in R&D. Some evidence is presented on the capital intensity of R&D.

Keywords: economic growth, capital accumulation, innovation, creative destruction

JEL classification: 040, 030, E22

1. Introduction

Is growth ultimately attributable to the accumulation of capital or to the accumulation of

knowledge (technological progress)? It is commonly argued that while both of these forces
contribute positively to growth in the short run, only the rate of technological progress
matters in the long run. According to this common view, capital accumulation plays at
best a passive, supporting role, affecting only the level of output, not its rate of growth.
Although the growth rate of an economy’s output will ultimately be the same as that of
the capital stock, the ultimate driving force determining both growth rates is technological
progress.
Although this common view has not been maintained by all who have written on economic
growth,1 it is a logical implication of almost all the widely used growth models that make
explicit the distinction between capital accumulation and technological progress. In the
neoclassical growth model of Solow and Swan, diminishing returns to capital accumulation
would eventually make any growth in excess of the rate of technological progress self-
limiting. Endogenous growth models that include capital as well as innovation (e.g., Romer,
1990; Grossman and Helpman, 1991, ch. 5) come to the same conclusion. For in these
models, the incentive to innovate determines the rate of technological progress, which in
112 PETER HOWITT AND PHILIPPE AGHION

turn determines the economy’s long-run growth rate, independently of the amount of capital
in the economy.2
The view that technological progress reigns supreme in the long run is also the consensus
view of mainstream textbooks. For example, Blanchard (1997, pp. 461, 496) asserts, in a
discussion of the sources of growth, that “growth must ultimately be due to technological
progress” and, in summary of a chapter on technological progress and growth, that “the rate
of output growth in steady state is independent of the saving rate.” David Romer (1996,
p. 95) states that, in knowledge-based endogenous growth models, “the driving force of
growth is the accumulation of knowledge . . . capital accumulation is not central to growth.”
We believe that this common view is mistaken. Capital and knowledge are two state
variables determining the level of output at any point of time. Only under special conditions
would a subsidy to the activities driving one of those state variables have no effect on the
long-run growth rate. In the general case, capital accumulation and innovation should be
complementary processes, both playing a critical role.
More specifically, just as capital accumulation cannot be sustained indefinitely without
technological progress to offset diminishing returns, so too technological progress cannot
be sustained indefinitely without the accumulation of capital to be used in the R&D process
that creates innovations and in the production process that implements them. This would
be true even in the absence of embodied technical progress and learning by doing, two
channels sometimes thought to provide a link between capital accumulation and long-run
growth.
In this article we formalize the argument of the preceding paragraphs by developing a
simple endogenous growth model that combines elements of the Solow-Swan neoclassical
model of capital accumulation and the Aghion-Howitt (1992) model of creative destruction.
The steady-state growth rate in the model is determined by the same factors as in our earlier
model of creative destruction and in addition by the incentive to accumulate capital, as
parametrized by a subsidy rate to the holding of capital. An increase in the capital-subsidy
rate will raise the incentive not only to accumulate capital but also to innovate, through
two channels. First, the increase in the capital stock will induce higher R&D through a
“scale effect.” That is, it will raise national income and hence raise the demand for the
products created by successful innovators, thus raising the reward to innovation. Second,
the increase in capital stock will reduce the cost of capital in the long run, and thus it will
reduce the capital component of the cost of R&D.
We argue (in Sections 4.1 to 4.3 below) that the absence of such an effect from previous
endogenous growth models with innovation and capital accumulation is a consequence of
a special and unrealistic assumption made in those models, to the effect that capital is not
used in the R&D technology that produces innovations.3
We also argue that the embodiment of new technologies in capital goods, important though
it might be as an empirical phenomenon, is not crucial to the main channel through which
capital accumulation affects growth. For most of our analysis we abstract from embodiment
by assuming that capital is perfectly malleable and can be transferred costlessly from one
use to another. When we take embodiment into account (in Section 4.4 below), it turns out,
somewhat paradoxically, that the effect of a capital subsidy on long-run growth, while still
positive, is reduced by this modification of the model.
CAPITAL ACCUMULATION AND INNOVATION IN LONG-RUN GROWTH 113

The significance of our main result is threefold. First, it suggests that recent evidence4
to the effect that investment is an empirically important determinant of long-run growth
does not in any way refute innovation-based endogenous growth theory. On the contrary,
the simple Schumpeterian endogenous growth theory developed below implies that capital
accumulation has a crucial role to play in promoting economic growth. For although R&D is
the proximate determinant of long-run growth, the level of R&D is an endogenous variable
that will be affected, even in the long run, by the incentive to accumulate capital. In the
extreme case where a prohibitive tax eliminated the incentive to accumulate capital, it would
also eliminate the incentive to perform R&D, and hence it would eliminate long-run growth.
Second, our main result offers hope to governments that have been faced by seemingly
insoluble agency problems when trying to increase growth by subsidizing R&D directly. For
it implies that direct subsidies to R&D are not needed to stimulate technological progress
and growth in the long run. A subsidy to capital accumulation in general can have the
same qualitative effect, while being less subject to agency problems because the production
of physical capital goods is generally easier to monitor and verify than the production of
intangible knowledge.
Third, the embodiment of new technologies in physical capital, which some have seen as
a possible reason for capital accumulation to affect the rate of technological progress, may
be less important than a hitherto unsuspected aspect of capital—namely, its role as an input
to R&D.

2. The Basic Model

The basic model is similar to the model of endogenous growth with capital presented in
Aghion and Howitt (1996), which in turn is a straightforward extension of our earlier model
without capital (Aghion and Howitt 1992), except that here we deal with out-of-steady-state
behavior, and we assume that intermediate products are produced by capital alone rather
than by capital and labor.5

2.1. Production Relations

There is a single final output, produced under perfect competition by labor and a continuum
of intermediate products, according to the production function
Z 1
Yt = Ait F(xit , L)di, (1)
0

where Yt is gross output at date t, L is the flow amount of labor used in producing the
final output,6 xit is the flow output of intermediate product i ∈ [0, 1], Ait is a productivity
parameter attached to the latest version of intermediate product i, and F() is a smooth,
concave, constant-returns production function. Assume that intermediate products are
necessary factors F(0, L) ≡ 0 and that

2F11 (x, L) + x F111 (x, L) < 0 for all x, L > 0. (2)

114 PETER HOWITT AND PHILIPPE AGHION

Condition (2) makes the marginal revenue of each intermediate producer a strictly de-
creasing function of that good’s output, which guarantees that the second-order conditions
for profit maximization are always satisfied. It holds in the special Cobb-Douglas case
F(x, L) ≡ x α L 1−α , 0 < α < 1, which we refer to from time to time. Unlike previous
attempts to integrate capital into Schumpeterian growth theory, however, our approach is
not restricted to any such special case.
Final output can be used interchangeably as a consumption or capital good or as an input
to R&D. Each intermediate product is produced using capital, according to the production
function

xit = K it /Ait , (3)

where K it is the input of capital in sector i. We divide K it by Ait in (3) to indicate

that successive vintages of the intermediate product are produced by increasingly capital-
intensive techniques.7
Innovations are targeted at specific intermediate products. Each innovation creates an
improved version of the existing product, which allows the innovator to replace the incum-
bent monopolist until the next innovation in that sector.8 The incumbent monopolist of each
good produces with a cost function equal to ζt K it = ζt Ait xit , where the cost of capital ζt is
the rate of interest (rt ) plus the rate of depreciation (δ) minus the subsidy rate to the holding
of capital (βk ):

ζt = rt + δ − βk .

The price schedule facing the monopolist is the marginal product schedule pit = Ait F1 (xit ,
L).
Since each intermediate firm’s marginal revenue and marginal cost schedule are both
proportional to Ait , and since the firms differ only in their value of Ait , they will all choose
to supply the same quantity of intermediate product xt = xit for all i. Putting this common
quantity into (3) and taking into account that the total demand for capital must equal the
given supply K t , we find

xit = xt = kt L , (4)

where kt is the capital stock per “effective worker” kt ≡ K t /At L, and At is the average
productivity parameter across all sectors.9
Substituting from (4) into (1) shows that output per effective worker is given by the
familiar intensive-form production function

Yt /At L ≡ yt = F(kt , 1) ≡ f (kt ), f 0 > 0.

Substituting from (4) into the profit-maximization condition of each intermediate firm, and
taking into account that F is homogenous of degree one, we find that the interest rate must
satisfy the equilibrium condition10

rt = R(kt ) − δ + βk , R 0 < 0, (5)

CAPITAL ACCUMULATION AND INNOVATION IN LONG-RUN GROWTH 115

where R() is each intermediate firm’s marginal revenue product function,11 which according
to (2) is strictly decreasing in kt . We also find that each local monopolist will earn a flow
of profits proportional to its productivity parameter Ait —namely,12

πit = Ait πt (kt )L , π 0 > 0.

The fact that profits are increasing in capital-intensity kt is crucial for understanding why
capital accumulation matters as well as innovation in determining the economy’s long-run
growth rate. It is an example of the sort of scale effect now common in Schumpeterian
growth models. As capital per efficiency unit rises, so does output per efficiency unit, and
so do profits. In the special Cobb-Douglas case, profits are a constant fraction of output
π(k) = α(1 − α) f (k).

2.2. Innovations

Improvements in the productivity parameters come from R&D activities that use final output
as the only hired input.13 The Poisson arrival rate φt of innovations in each sector is

φt = λn t , λ > 0, (6)

where λ is a parameter indicating the productivity of R&D, and n t is the productivity-

adjusted quantity of final output devoted to R&D in each sector—that is, R&D expenditure
divided by the “leading-edge technology parameter” Amax t ≡ max{Ait | i ∈ [0, 1]}. We
deflate expenditures by Amaxt to take into account the force of increasing complexity; as
technology advances, the resource cost of further advances increases proportionally.14 This
assumption prevents growth from exploding as the capital used in producing R&D grows
without bound.
The same amount of input n t (adjusted for the leading-edge productivity parameter) will
be used in R&D in each intermediate sector because the prospective payoff is the same
in each sector. Specifically, each innovation at date t results in a new generation of that
intermediate sector’s product, which embodies the leading-edge productivity parameter
Amax
t .
Assume that R&D expenditures are subsidized at the rate βn . Then the arbitrage condition
governing the equilibrium level of R&D is that the marginal net cost of a unit of R&D
expenditure equal the expected marginal gain. Since a unit of R&D expenditure raises the
Poisson arrival rate by λ/Amaxt , this yields
Z ∞ Rτ
− (rs +φs )ds
1 − βn = λ e t π(kτ )Ldτ, (7)
t

where rs is the instantaneous rate of interest at date s. The instantaneous discount rate
applied in (7) is the rate of interest plus the rate of creative destruction φs ; the latter is the
instantaneous flow probability of being displaced by an innovation.15
116 PETER HOWITT AND PHILIPPE AGHION

Setting the time derivative of the right-hand side of (7) equal to zero and using (6) yields
the more familiar arbitrage equation
π(kt )L
1 − βn = λ ,
rt + λn t
which can be solved, using (5), for the R&D intensity n t as an increasing function of the
capital intensity kt :
n t = ñ(kt ), ñ 0 > 0. (8)
The R&D function ñ is increasing because as capital increases, the flow of profits π(k)
earned by a successful innovator rises, and the rate of interest R(k) − δ + βk at which those
profits are discounted decreases. On both counts the prospective reward to R&D increases,
which induces a rise in the intensity of R&D.

2.3. Technological Progress and Capital Accumulation

Growth in the leading-edge parameter Amax t occurs as a result of the knowledge spillovers
produced by innovations.16 That is, we follow Caballero and Jaffe (1993) in assuming that
at any moment of time the leading-edge technology is available to any successful innovator,
and this publicly available (but not costless) knowledge grows at a rate proportional to the
aggregate rate of innovations. The factor of proportionality, which is a measure of the
marginal aggregate impact of each innovation on the stock of public knowledge, is σ > 0.
Thus the rate of technological progress at each date equals
gt ≡ Ȧmax
t /Amax
t = σ λn t . (9)
One can show that the ratio of the leading edge Amax
t to the average productivity parameter At
will converge monotonically to the constant17 1+σ . Thus we assume that Amax t = At (1+σ )
for all t, so that the rate of growth of the average productivity parameter At will also be
given by (9).
The rate of change of the capital stock per efficiency unit kt is given by
k̇t = f (kt ) − ct − n t (1 + σ )/L − (δ + gt )kt , (10)
where δ is the rate of capital depreciation and ct is consumption per efficiency unit of labor.
The first three terms on the right-hand side of (10) represent gross capital accumulation per
efficiency unit, which is GDP minus consumption minus the resources used up in R&D, all
expressed in efficiency units.18 The remaining terms represent the reduction in the capital
stock per efficiency unit that takes place through depreciation and the increase in the number
of efficiency units.

2.4. Equations of Motion

We make the conventional assumption that saving is determined by intertemporal utility

maximization on the part of a representative consumer, who has intertemporally additive
CAPITAL ACCUMULATION AND INNOVATION IN LONG-RUN GROWTH 117

preferences over consumption, a constant rate of time preference ρ and a constant elasticity
of marginal utility ε. As usual this implies that ct must obey the Euler equation19

d
(At ct )−ε = (ρ − rt )(At ct )−ε ,
dt
which can be rewritten, using (9), as

ċt = ct [(rt − ρ)/ε − gt ]. (11)

Equations (10) and (11) are the usual equations of the Cass-Koopmans-Ramsey model
of optimal growth, modified to include labor-augmenting technological progress. The only
novelty is that the rate of technological progress gt is no longer an exogenous constant but
depends on the R&D intensity n t . These equations can be reduced, with the aid of (5), (8),
and (9), to the two-dimensional system in capital intensity kt and consumption intensity ct :

k̇t = f (kt ) − ct − ñ(kt )(1 + σ )/L − [δ + σ λñ(kt )]kt

ċt = ct [(R(kt ) − δ + βk − ρ)/ε − σ λñ(kt )].

The system’s rest point (k̂, ĉ) is a steady-state equilibrium with balanced growth in the usual
sense. The steady state is locally stable, in the sense that for any initial capital intensity
in a neighborhood of k̂ there is a unique initial value of c that puts the system on a stable
trajectory converging monotonically to the steady state.20

3. Steady-State Analysis

The steady-state values of capital intensity (k), R&D intensity (n), the rate of interest (r ),
and the rate of growth of output per person (g) are defined by the following equations:

R(k) = r + δ − βk (K)
1 − βn = λ π(k)L
r +λn
. (N)
r = ρ + εg (R)
g = σ λn. (G)

Equation (K) equates the cost of capital to its marginal revenue product. Equation (N) is
the same equation that defines the steady-state R&D intensity in the Aghion-Howitt (1992)
model. It equates the marginal cost of R&D (which was a productivity-adjusted wage in
Aghion-Howitt model where labor was the only R&D input) to the expected discounted
marginal benefit. Equation (R) is the familiar Fisher equation showing how the rate of
interest depends on the growth rate of consumption. Equation (G) is the spillover equation
determining the rate of technological progress and hence the steady-state rate of growth.
Straightforward comparative-statics techniques yield the following proposition:

Proposition 1: The steady-state growth rate g depends positively on the two subsidy rates
(βk , βn ), the productivity of R&D (λ), and the size of innovations (σ ); and negatively on the
118 PETER HOWITT AND PHILIPPE AGHION

elasticity of marginal utility (ε), the rate of time preference (ρ), and the rate of depreciation
(δ).
Most of the specific results of Proposition 1 are unremarkable, except for the positive
effect of the capital subsidy rate. To see more clearly how this works, use equations (R)
and (G) to eliminate r from the first two equations. This leaves the two-dimensional system
illustrated in Figure 1. The capital curve (K) is downward sloping because higher R&D
intensity raises the rate of growth, which raises the interest rate through the Fisher relation,
which reduces the steady-state demand for capital. The R&D curve (N) is upward sloping
because more capital raises the flow of profits π(k)L to a successful innovator.21 An increase
in the subsidy rate on capital shifts the capital curve to the right, raising the steady-state
R&D intensity. The steady-state growth rate increases according to the growth equation
(G).
In addition to having a positive marginal effect on growth, capital accumulation is neces-
sary for growth to be sustained in the long run. Suppose that the capital tax were continually
raised in such a way as to ensure that the capital stock per worker K t /L were frozen. Then
positive long-run technological progress would imply a capital stock per effective worker
kt that approached zero in the long run. Since capital is assumed to be a necessary factor
of production, this would drive output per effective worker, and hence profit per effective
worker π(kt ), to zero in the long run. (In addition, if we had imposed an Inada condition on
the production function F the rate of interest would have been driven to infinity.) Thus the
reward to innovation on the right-hand side of the steady-state equation (N) would be driven
to zero, making it impossible for the condition to be satisfied. In this way, a prohibitive tax
on capital accumulation would eventually choke off long-run growth, just as a prohibitive
tax on R&D would.

4. Capital Accumulation and Growth

The result that a subsidy to capital can permanently raise growth runs counter to the con-
ventional belief that the long-run rate of growth is unaffected by capital accumulation, a
belief that is supported by the neoclassical growth model of Solow and Swan, in which
technical progress drives long-run growth independently of capital accumulation, and by
the endogenous growth models of Romer (1990) and Grossman and Helpman (1991, ch. 5),
in which the incentive to perform R&D determines the long-run growth rate independently
of the stock of capital.

4.1. Capital as an Input to R&D

The key difference between the model we have just presented and these other endogenous
growth models is that we assume R&D uses the same mix of inputs as does the production
of capital and consumption goods, whereas these other models assume that the only input to
R&D is a factor that is fixed in supply, independently of its rate of remuneration. Although
the factor is often referred to as “human capital,” the fact that it cannot be accumulated even
CAPITAL ACCUMULATION AND INNOVATION IN LONG-RUN GROWTH 119

Figure 1. Determination of steady-state values of R&D (n) and capital per effective worker (k).

temporarily in response to a change in its price makes it just like the labor in the present
model.
The reason that this difference is so important can be seen by provisionally modifying
the above model to make labor the only R&D input. In this modified model the flow of
aggregate output would be determined by equation (1) above, except that the labor input
to manufacturing would be L − n instead of L, where n is the labor used in R&D. The
flow of innovations would be, as before, λn. By exactly the same reasoning as before, the
steady-state arbitrage equation would be

π(k)(L − n)
(1 − βn )ω(k) = λ ,
r + λn
where k ≡ K t /At (L − n) is now the ratio of capital to manufacturing labor in efficiency
120 PETER HOWITT AND PHILIPPE AGHION

units, and ω(k) ≡ 1+σ 1

F2 (k, 1) is the real wage divided by Amax under our assumption of
perfect competition in the final goods sector. The rest of the equations defining a steady
state would be unaffected by this change.
Thus, restricting labor to be the only input to R&D would give an offset to the positive
effect of capital on innovation. For an increase in capital would raise the marginal product
of labor in manufacturing, thus raising the cost ω(k) of the only input to R&D. This would
tend to counteract the rise in profits to a successful innovator. In fact, in the special case of
a Cobb-Douglas technology, the two effects would exactly cancel because ω(k) and π(k)
would both be proportional to output per effective worker f (k). In this special case the
R&D curve (N) in Figure 1 would be horizontal, so a change in the capital subsidy that
shifted the capital curve (K) would not affect the steady-state R&D intensity.
However, as long as R&D used any capital at all this conclusion would not be valid. The
general result in the Cobb-Douglas case is that when capital intensity increases, the cost
of R&D rises less than in proportion to the equilibrium flow of profit, and hence R&D and
growth both increase. Suppose, for example, that R&D used capital and labor according to
a standard constant-returns production function

n = G n (K n /Amax , L n ),

where n is now the intensity of R&D, and K n , L n are the amounts of capital and labor used
in R&D in each sector. Then the R&D equation (N) would be

h ³ ´i
π(k) L − na Ln ω(k)
R(k)
(1 − βn )cn (R(k), ω(k)) = λ , (12)
r + λn

where cn is the unit cost function22 associated with the production function G n , and a Ln is
the unit demand function for labor in R&D. If R&D uses any labor at all, then the elasticity
of cn with respect to ω is less than unity. Thus in the Cobb-Douglas case where ω and π are
proportional to each other, when k increases, the resulting increase in the cost of R&D that
works through the wage rate will be less than proportional to the rise in profit. The overall
effect will be a net stimulus to R&D.
In addition, equation (12) indicates two further effects that will each give a stimulus to
R&D. First, the cost of capital used in R&D (ζ = R(k)) will fall. Second, the rise in the
wage-rental ratio will induce R&D firms to economize on their use of labor, which would
leave more in the manufacturing sector if R&D intensity were not to increase. The resulting
increase in output per product would raise the flow of profit per product, thus inducing R&D
intensity to increase.
Moreover, even if labor were the only R&D input, a subsidy to capital accumulation
would raise growth in the Cobb-Douglas case if there were any positive elasticity at all to
the supply of labor because while the rise in profits per effective worker would raise the
reward to labor as much in manufacturing as in R&D, the overall rise in the wage would
induce an increased supply.
CAPITAL ACCUMULATION AND INNOVATION IN LONG-RUN GROWTH 121

Figure 2. Capital expenditures on R&D in higher education as a percentage of total higher education R&D
expenditures.

4.2. Some Evidence

In fact, neither of the assumptions needed to avoid the positive effect of a capital subsidy on
long-run growth is very plausible. R&D actually uses a great deal of physical capital, in the
form of laboratories, offices, plant, and equipment needed for constructing and testing pilot
models and prototypes, computers and other scientific instruments, particle accelerators,
observatories, space vehicles, and so forth. Direct evidence on capital intensity in U.S. R&D
is almost nonexistent, but at least two bits of indirect evidence exist. First, in assembling
satellite R&D, the U.S. Department of Commerce (Carson et al, 1994, p. 56) estimated that
depreciation of equipment and structures constituted 6.5 percent of the value added (total
expenditure minus the cost of materials and supplies) by Industrial R&D in 1987, which
was 52.4 percent of the national depreciation/GDP ratio for that year.
Second, as Figure 2 shows, between 1979 and 1989 the ratio of capital R&D expenditures
to total R&D expenditures in higher education in the United States was 0.136.23 If materials
122 PETER HOWITT AND PHILIPPE AGHION

Table 1. Components of U.K. BERD (percentage).

1969 1978 1981 1985 1989

Capital spending 10 10 9 10 11
Wages and salaries 50 48 44 42 42
Materials 21 21 23 22 21
Other 19 21 24 26 27

Source: Cameron (1996).

and supplies constituted the same percent of total R&D expenditure each year in higher
education as in industry24 then the average ratio of gross investment to value added was
0.166. This ratio is actually larger than the national average; the ratio of gross fixed
investment to GDP during these years was 0.162, while the ratio of gross fixed nonresidential
investment to GDP was 0.117. These observations, tenuous though they might be, suggest
that, if anything, the assumption of a capital intensity in R&D equal to that of the rest of the
economy is probably closer to the truth than the assumption of a zero R&D capital intensity.
This evidence is corroborated by data on business enterprise R&D in the United Kingdom,
as shown in Table 1. These data show that capital expenditures have constituted about 10
percent of total R&D expenditures since the late 1960s, or about 12.5 percent of value added
(ie of total expenditures minus materials expenditures).
Also, although there may not be a significant long-run elasticity to the supply of unskilled
labor, there is no reason to doubt that a rise in the skill premium would induce a significant
supply response of the skilled labor used intensively in R&D. People would remain in
school for longer periods, demand a higher quality of education, and engage in more
training and other skill-acquisition activities. The resulting increase in the supply of skills
would dampen the rise in the cost of R&D without dampening the rise in the payoff to a
successful innovator. To be more precise, if skilled and unskilled wages were to rise by
equal proportions when the capital stock rose, as they would if both skilled and unskilled
labor worked with capital in a Cobb-Douglas aggregate production function, the rate of
return to investing in skills would increase with the capital stock unless labor were the only
factor of production used in acquiring skills. But, in fact, labor is not the only input to
skill acquisition. Higher education uses a lot of physical capital in the form of buildings,
computers, and other facilities. In addition, the experience of working with modern capital
equipment is one of the most important inputs to acquiring skills through learning by doing.

4.3. The Role of Human Capital

In order to see more clearly the role of human capital in R&D, we now briefly consider
a disaggregated model that distinguishes explicitly between physical and human capital.
Suppose first that both types of capital are produced by the same technology as consumption
and R&D and that intermediate products are produced according to a constant-returns
production function

xit = G(K it , Hit )/Ait .

CAPITAL ACCUMULATION AND INNOVATION IN LONG-RUN GROWTH 123

Then the same reasoning as before leads to the steady-state equations

Rk (k, h) = r + δk − βk (K0 )
Rh (k, h) = r + δh − βh (H0 )
π(k, h)L
1 − βn = λ (N0 )
r + λn
r = ρ + εg (R)
g = σ λn, (G)
where βh is the subsidy rate to human capital, h is human capital per effective worker, Rk
is the marginal revenue product of physical capital, defined as

Rk (k, h) ≡ [F1 (G(k, h), 1) + G(k, h)F11 (G(k, h), 1)]G 1 (k, h),

Rh is the (analogously defined) marginal revenue product of human capital, and π is profit
per effective worker

π(k, h) ≡ −G(k, h)2 F11 (G(k, h), 1).

It is straightforward to solve equations (K0 ) and (H0 ) and substitute into the profit function
π to get the indirect profit function π̃ (r + δk − βk , r + δh − βh ), π̃1 , π̃2 < 0. Substituting
this into (N0 ) and using (R) and (G) to eliminate r and n yields the growth equation

π̃(ρ + εg + δk − βk , ρ + εg + δh − βh )L
1 − βn = λ .
ρ + εg + g/σ
Using this equation it is straightforward to verify that all the comparative-statics results
of Proposition 1 above go through in this disaggregated model and that, in addition, an
increase in the human-capital subsidy rate (βh ) raises the steady-state growth rate.
Even if human capital were the only factor of production used in R&D, the only difference
this would make would be to the arbitrage equation (N0 ), which would become
π(k, h)L
(1 − βn )(r + δ − βh ) = λ ,
r + λn
where now h and k represent the ratios of human and physical capital to effective workers
in manufacturing. Again, Proposition 1 would be valid. In this case, any tendency for the
cost of R&D to be driven up by a subsidy to physical capital would be offset completely by
an infinitely elastic supply response of human capital.

4.4. The Embodiment Hypothesis

It is sometimes argued that subsidizing capital accumulation can affect long-run growth
because it accelerates the rate at which technological progress is embodied in new capital
goods. We are convinced by the arguments in Scott (1989) and others that capital does
indeed embody new technologies and that this fact renders almost meaningless accounting
124 PETER HOWITT AND PHILIPPE AGHION

exercises designed to measure the relative importance of capital and technology. However,
we have ignored embodiment up to this point in the interest of simplicity. For although
we have assumed that capital is needed to produce new intermediate products, the capital
goods themselves have not been assumed to be specific to any particular technology. That
is, implicit in our derivation of the cost of capital was the assumption that when a new
innovation displaces an incumbent in an intermediate sector, the capital that the incumbent
has been using can be reconstituted at no cost and used to produce the new generation of
intermediate product. (That is, we were assuming putty-putty.)
The results of the previous sections show clearly that the embodiment hypothesis is not
crucial for the result that a capital subsidy will affect long-run growth. What we show in
the present section is that incorporating embodiment actually has the paradoxical effect
of weakening the result, although not overturning it. For the fact that capital embodies a
particular technology increases the positive effect of R&D on the cost of capital. This is
because it increases the expected rate of obsolescence, which must be added to the rate of
depreciation in computing that cost. This obsolescence effect will dampen the effect on
R&D of a capital subsidy because as R&D increases in response to the subsidy, it raises the
cost of capital, thus counteracting the original stimulus.
To see how this works we now go to the other extreme (putty-clay) and assume that each
new innovator must use entirely new capital goods.25 The only difference this makes to the
steady-state equations of Section 3 is to add the expected rate of depreciation λn to the cost
of capital. That is, equation (K) is replaced by

R(k) = r + δ − βk + λn.

It is easily verified that with this modified system of equations, the capital curve in Figure 1
will be shallower than before. An increase in the subsidy rate βk will shift the shallower
curve to the right by the same amount as before. Thus the resulting increases in both k and
n will be less than before.
If in addition to embodiment we assumed that the rate of technological progress depends
on the rate of learning by doing, which in turn depends on the rate of investment, then
we would have an additional channel through which capital accumulation affects long-run
growth. But without this extra learning-by-doing dimension, embodiment by itself does
not provide such a channel. For a speed up of investment may just result in more capital
goods of each technological vintage rather than a faster rate of improvement of the capital
goods, with no stimulus to the rate of technological progress that proximately determines
the long-run growth rate.

5. Conclusions

In summary, we have presented a Schumpeterian growth theory that treats capital accu-
mulation and innovation as equal partners in the growth process. The model incorporates
in a simple framework the essential elements of the Solow model of capital accumulation
and the Aghion-Howitt model of creative destruction. Contrary to the consensus view of
neoclassical growth theory and other endogenous growth theories, a subsidy to capital accu-
CAPITAL ACCUMULATION AND INNOVATION IN LONG-RUN GROWTH 125

mulation, either physical or human, will have a permanent effect on the economy’s growth
rate. The key to this result is the recognition of capital as an input to R&D.
These results offer hope to governments that have been faced by seemingly insoluble
incentive problems when trying to subsidize R&D directly. For they imply that a broad
subsidy to capital accumulation in general may be just as effective a means of stimulating
technological progress and growth in the long run as a direct subsidy to R&D. Such a subsidy
might work not by inducing a higher rate of technological progress through learning by doing
or through increasing the rate at which new technologies are embodied in new capital goods,
but rather by raising the reward to innovations that need capital for their production and
implementation.26
Moreover, the results show that Schumpeterian endogenous growth theory is not refuted
by recent evidence to the effect that investment is an empirically important determinant of
long-run growth. Indeed, the Schumpeterian theory developed above is more consistent
with this evidence than is the neoclassical theory of Solow and Swan, in which long-run
growth is driven by exogenous technological progress that takes place independently of
the incentive to accumulate capital. Our model provides a simple vehicle for exploring the
relative roles of capital accumulation and innovation in long-run growth, without eliminating
one of them a priori as does neoclassical growth theory.

Appendix: Allowing Previous Innovators to Compete

This appendix modifies the assumption concerning competition between the latest innovator
in a product and previous innovators in the same product. In the text we assumed that once
the previous innovators had left, they were unable to reenter. Thus the latest innovator was
never threatened by a competitive fringe. Here we make the opposite assumption—namely,
that the previous innovator is always able to reenter at no cost.
This means that if someone innovates in a product where the previous innovation took
place very recently, then the difference in quality between the latest generation of the product
and the previous one will not be large enough for the latest innovator to ignore the threat
of competition from the previous innovator. In the language of the patent race literature
(Tirole, 1988, ch. 10), the innovation will be nondrastic.
More specifically, suppose that the latest innovator in intermediate product i has a pro-
ductivity parameter Ai , while the previous innovator has Āi . Suppose that the innovations
in all other sectors are drastic. Then the price charged by each local monopolist will be the
marginal product

p j = A j F1 (x j , L) = A j F1 (k, 1), (13)

where we have made use of (4) and of the linear homogeneity of the production function
F.
The latest innovation in intermediate product i will be drastic if and only if no final-good
producer will buy the previous generation of the product in a situation where the latest
126 PETER HOWITT AND PHILIPPE AGHION

innovator is charging a price given by (13) and the previous innovator is charging a price
p̄i equal to marginal cost

p̄i = Āi ζ. (14)

A final-good producer will buy from the previous innovator at this price if and only if the
variable profit it makes using that version of intermediate product i is larger, per worker
employed, than if it used the latest version. In that case the producer will buy the quantity
x̄i per worker employed, such that the marginal product equals the price (14)

F1 (x̄i , 1) = ζ. (15)

Making use of Euler’s theorem, (4), and (13) to (15), we can express the variable profit per
worker employed in the two cases as
Ai F(x, L) − pi x
πi ≡ = Ai [F(k, 1) − k F1 (k, 1)] = Ai F2 (k, 1)
L
and

π̄ ≡ Āi F(x̄i , 1) − p̄i x̄i = Āi [F(x̄i , 1) − x̄i F1 (x̄i , 1)] = Āi F2 (x̄i , 1).

So the innovation will be drastic if and only if πi ≥ π̄i —that is, if and only if

Ai F2 (k, 1) ≥ Āi F2 (x̄i , 1), (16)

where x̄i is determined by

F1 (x̄i , 1) = F1 (k, 1) + k F11 (k, 1). (17)

Equation (17) follows from (15), the equilibrium condition (5) and the definition of the cost
of capital ζt .
Consider now the Cobb-Douglas case F(x, L) ≡ x α L 1−α . It follows in this case from
(16) and (17) that the innovation will be drastic if and only if

Ai (1 − α)k α ≥ Āi (1 − α)x̄iα ,

where x̄i is determined by

α x̄iα−1 = α 2 k α−1 .

That is, if and only if

α
Ai / Āi ≥ α α−1 . (18)

In this Cobb-Douglas case there will exist a stationary equilibrium in which all innovations
are drastic, under the condition that
α ln α
< 1. (19)
α−1 σ
CAPITAL ACCUMULATION AND INNOVATION IN LONG-RUN GROWTH 127

To construct such an equilibrium, note that given the linear R&D technology, no R&D at
date t will be targeted at sectors whose technological vintage is later than t − T , where T
is determined by the conditions that (18) hold with equality
α α ln α
e gT = α α−1 , or T = . (20)
α−1 g
If older sectors are targeted, any resulting innovation will be drastic, resulting in a profit
flow of π(k) until the next innovation, whereas if a newer sector was targeted, the resulting
innovation would be nondrastic, resulting in a lower profit flow. Since the value of innovating
in the newer sectors will be less than in the older sectors, only the older sectors will be
targeted.
Let n again be the economywide R&D intensity in a steady-state equilibrium. Let f
denote the fraction of all sectors that are targeted by R&D—that is, the fraction that are at
least as old as T . The flow of new untargeted sectors is the flow of innovations λn. Each one
remains untargeted for a period of length T . Thus at any date in a steady-state equilibrium,
the mass 1 − f of untargeted sectors is the cumulative flow of new ones over the past T
units of time

1 − f = λnT. (21)

According to (20), (21), and the growth equation g = σ λn, condition (19) is necessary for
f to be positive.
The productivity-adjusted value of an innovation v at any date is the flow of expected
discounted profits π(k). The discounting must now take into account that for the first T
units of time after the innovation there is no risk of creative destruction; the innovator will
be untargeted. After T , the innovator will be subject to a Poisson destruction rate of

φ = λn/ f, (22)

since there will be a flow of λn innovations per unit of time spread over a mass f of products.
Hence
µZ T Z ∞ ¶
π(k) £ ¤
v = π(k) e−r s ds + e−r T e−(r +φ)s ds = 1 + (1 − e−r T )φ/r .
0 0 r +φ
(23)

As before, the steady-state capital intensity k will be determined by equation (K) above,
and the rate of interest by the Fisher equation (R). Hence, we can write the flow of profit as

π(k) = π̃(ρ + εg + δ − βk ), π̃ 0 < 0. (24)

Combining equations (20), (22), (23), and (24) and the arbitrage condition 1 − βn = λv, we
get the final equation determining the steady-state growth rate in the Cobb-Douglas case:
π̃(ρ + εg + δ − βk ) h ³ α(ρ+εg)
´ i
1 − βn = λ 1 + 1 − α (1−α)g g/σ f (ρ + εg) , (25)
ρ + εg + g/σ f
128 PETER HOWITT AND PHILIPPE AGHION

where by (20), (21), and the growth equation (G), f is given by

α ln α
f =1− .
α−1 σ
Since the right-hand side of (25) is increasing in βk and the left-hand side is decreasing in
βn , once again a subsidy to either innovation or capital accumulation will raise the steady-
state growth rate, provided that the right-hand side of (25) is decreasing in g. To show this,
note that the effects of g working through the argument of the indirect profit function π̃ and
through the exponent of α are both negative. The remaining effects have the same sign as
the effect of g on
1
[1 + ξ g/σ f (ρ + εg)], (26)
ρ + εg + g/σ f
α(ρ+εg)
where ξ(= 1 − α (1−α)g ) is held constant. Note that (26) can be rewritten as
(ρ + εg + ξ g/σ f ) 1
,
(ρ + εg + g/σ f ) (ρ + εg)
which is decreasing in g because ξ < 1.

Acknowledgments

This article is part of a broader project on growth theory, the results of which are described
at length in our recent book (Aghion and Howitt, 1998). We have benefited from com-
ments of seminar participants at the Canadian Institute for Advanced Research, the Ohio
State University, and the European Science Foundation conference on growth theory in
Castelvecchio Pascoli, especially Gavin Cameron.

Notes

1. For example, it is not supported by the AK version of endogenous growth theory, according to which techno-
logical progress and capital accumulation do not constitute independent causal forces in the growth process.
2. Barro and Sala-i-Martin (1995) do not consider models with both capital accumulation and innovation. The
only model we have found in the literature that does not imply the common result is the “lab-equipment”
model of Rivera-Batiz and Romer (1991), who do not, however, discuss the issue of capital accumulation
versus innovation.
3. One way to see what is at issue is to suppose that output (Y ) is determined by capital (K ) and technological
knowledge (A) according to y = K α A1−α and that the accumulation of capital and knowledge are governed
by fixed savings rates K̇ = s K Y , Ȧ = s A Y . The steady-state growth rate g = s Kα s 1−α
A depends positively on
s K , holding s A constant. The above-mentioned endogenous growth models imply however that s K and s A are
not independent of each other and that an increase in s K would cause an exactly offsetting decrease in s A , with
no overall effect on the growth rate. What we argue below is that this exact offset is a polar case.
4. For example, DeLong and Summers (1991) and Mankiw, Romer, and Weil (1992). In Aghion and Howitt
(1998, ch. 12) we argue that innovation-based growth theory is also consistent with the growth accounting
evidence of Jorgenson (1995) and Young (1995), with evidence on conditional convergence and with Jones’s
(1995) evidence on the absence of a scale effect in postwar data.
CAPITAL ACCUMULATION AND INNOVATION IN LONG-RUN GROWTH 129

5. This same simplifying assumption was made by Romer (1990). A detailed analysis of the present model in
the case where both labor and capital enter the production function for intermediate products is contained in
Howitt (1997, app. A).
6. We abstract in this article from population growth and labor supply by assuming L to be an exogenous constant.
See Howitt (1997) for a treatment of population growth in a similar model.
7. In the special case of a Cobb-Douglas technology this has no substantive implications.
8. No innovations are done by incumbents because of the Arrow or replacement effect (see Aghion and Howitt,
1992).
R1
9. From (3), the definition of At and the adding up condition, we have K t = 0
Ait xt di = At xt .
10. After substitution from (4), the first-order condition is ζt = F1 (kt L , L)+kt L F11 (kt L , L). By Euler’s theorem,
F1 is homogeneous of degree zero and F11 is homogeneous of degree −1. Hence ζt = F1 (kt , 1)+kt F11 (kt , 1).
Equation (5) follows from this and the definitions of ζt and R(kt ).
11. That is, R(kt ) ≡ F1 (kt , 1) + kt F11 (kt , 1)
12. Specifically, π(kt ) ≡ −kt2 F11 (kt , 1), which according to (2) is strictly increasing in kt .
13. Or, equivalently, they use intermediate products and labor according to the same technology as in the final
goods sector. Barro and Sala-i-Martin (1995, chs. 6, 7) make the same assumption.
14. Howitt (1997) shows that the analysis can easily be generalized to the case in which φt = λφ(n t ), where the
function φ exhibits the decreasing returns found empirically by Arroyo, Dinopoulos, and Donald (1994) and
Kortum (1993).
15. We assume that each innovator enters into Bertrand competition with the previous incumbent in that sector, who
by definition produces an inferior product. Rather than face a price war with a superior rival, the incumbent
exits. Having exited, the former incumbent cannot threaten to reenter. This is why the local monopolist can
always charge the unconstrained monopolist price without worrying about competition from earlier vintages
of the product (see the appendix for the generalization to the case where the previous incumbent can always
reenter at no cost).
16. See, for example, the historical analysis of Rosenberg (1963) or Griliches’s (1992) survey of econometric
work.
17. Each innovation replaces a randomly chosen Ait with the leading edge Amax t . Since innovations occur at the
rate φt per product and the average change across innovating sectors is Amax
t − At , we have

d At
= φt (Amax
t − At ).
dt
This and equation (9) imply that the ratio Ät = Amax
t /At evolves according to

1 dÄt
= φt σ − φt (Ät − 1).
Ät dt
It follows that as long as φt is bounded above zero, Ät will converge asymptotically to 1 + σ , as asserted in
the text.
1+σ
18. Because n t is R&D input per product divided by Amax
t , it must be multiplied by L .
19. Since there is a continuum of sectors with independent risks of creative destruction, investing in R&D involves
only diversifiable risk. Hence rt is a risk-free rate.
20. That is, the rest point exhibits saddle-point stability. This can be demonstrated by showing that the Jacobian
matrix
" ¡ 1+σ ¢ #
h i f 0 (k̂) − δ − g − ñ 0 (k̂) + σ λk̂ −1
J≡
∂ k̇/∂k ∂ k̇/∂c
= h i L
∂ ċ/∂k ∂ ċ/∂c R 0 (k̂)
(k,c)=(k̂,ĉ) ĉ ε − σ λñ 0 (k̂) 0

has a negative determinant, which follows from direct calculation, since R 0 (k) < 0 and ñ 0 (k) > 0.
21. The fact that these two curves have opposite signed slopes guarantees uniqueness of the steady state.
22. That is, cn (ζ, ω) ≡ Min ζ κ + ωη subject to G n (κ, η) = 1.
130 PETER HOWITT AND PHILIPPE AGHION

23. These data come from the National Science Foundation’s annual survey of research and development expen-
ditures at universities and colleges, as presented in the NSF data retrieval system WebCaspar.
24. The ratios for industry are taken from Jankowski (1990).
25. Thus each innovation can be thought of as a new intermediate product, combined with a new capital good to
produce it.
26. If, however, we took into account some of the agency problems involved in managing firms we would find that,
at least in some cases, subsidizing capital accumulation can retard innovation by giving non-profit-maximizing
managers financial relief from the competitive pressure to innovate. For more details, see Aghion and Howitt
(1998, ch. 7).

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