Macroeconomics (HUL213)

Lecture 08-09
Feb 01 & 08; 2024
Growth and Ideas
Antibiotic example
For figure in the next slide
Pareto Optimality-1

▶ Pareto optimality: There is no alternative allocation to make

someone else better off without making someone else worse
off.
▶ Two Pareto optimal solutions: suppose $100 falls out of the
sky into the classroom.
▶ A Pareto optimal allocation is to divide it equally among
everyone in the class.
▶ Another Pareto optimal allocation is to give it all to me.
▶ Perfect competition results in a Pareto optimal solution in
markets:
MC = MB = P
▶ Prices allocate scarce resources to their appropriate uses.
Pareto Optimality-2
Under increasing returns,
▶ No firm will invest in new ideas if P = MC .
▶ There is an initial fixed cost (in addition to the marginal cost) of
production. Firms will not have an incentive to engage in RD if
there is no return.
▶ Consider the antibiotic example:
▶ Pharmaceutical companies would not produce a new drug if
P = MC .
▶ They would have to spend millions of dollars on research
before manufacturing the new antibiotic.
▶ If P = MC , the initial fixed costs of R&D will never be
recovered.
▶ Pharmaceuticals would need to sell at a price greater than
marginal cost to recoup the original cost.
▶ After the new idea is created, production continues with constant
returns to scale and constant marginal cost.
▶ However, at some point, for invention to occur, there must be a
wedge between P and MC .
Incentives, competition and innovation

▶ The incentives embedded in the wedge between price and

marginal cost imply that there cannot be perfect competition
and innovation.
▶ Patents and copyright systems create monopoly power for 20
years, in exchange for the inventor making the knowledge
underlying the discovery public.
▶ This is one justification for the patent and copyright systems.
▶ Patents reward innovators with monopoly power for 20 years,
providing a temporary wedge between price and marginal cost
that leads to profits.
▶ Profits provide an incentive for the inventor to create new
ideas.
Incentives, competition and innovation

▶ In industries such as financial services, patents are uncommon.

▶ So, the markup over marginal cost comes through trade
secrets: withholding the details of a particular idea from
competitors. The unintended negative consequence of
monopoly power is that some consumers are priced out of the
market and cannot afford the good.
▶ This can result in a welfare loss. A single price cannot
simultaneously provide the appropriate incentives for
innovation and allocate scarce resources efficiently.
▶ Other incentives for production include: Government funding
(such as the “National Innovation Foundation-India” by
Department of Science and Technology, Government of India)
Prizes.
Case Study: Open Source Software and Altruism

▶ Profits are not the only way to encourage innovation

▶ Other motives:
▶ Altruistic generosity
▶ Desire to signal skills
▶ “Purpose motives”: For example,
▶ Linux
▶ Apache
Case Study: Open Source Software and Altruism

▶ Open Source Software programmers may be motivated by

altruistic generosity or by a desire to signal their skills to
others.
▶ Computer software programs like Linux (a computer operating
system) and Apache (a program for running Web sites) are
examples of sophisticated software programs that are available
for free.
▶ In this case, the marginal cost of making additional copies of
the software is essentially zero.
▶ Many people are willing to spend their free time writing and
improving such computer programs.
▶ Feelings of altruism may account for part of the motivation,
as well as a desire to show off programming skills to other
people, including potential employers or venture capitalists.
▶ Output per person grows at a constant rate in the Romer
model, so it appears as a straight line on this graph with a
ratio scale.
▶ Recall that the ratio scale has a compressed vertical axis.
▶ The value of 100 in the year 2000 is simply a normalization
Transition Dynamics: Romer vs Solow
▶ The Romer model is unlike the Solow model in that it does not exhibit
transition dynamics.
▶ The growth rate is constant at all points in time.
▶ Since the growth rate never rises or falls, in some sense the economy
could be said to be in its steady state from the start.
▶ Because the model features sustained growth, it seems a little odd to call
this a steady state.
▶ For this reason, economists refer to such an economy as being on a
balanced growth path, where the growth rates of all endogenous variables
are constant.
▶ The Romer economy is on its balanced growth path at all times, as long
as the parameter values are not changing.
▶ Changes in some parameters of the model can change the growth rate.
▶ In the Solow model, an economy may start out by growing (if it begins
away from the steady state).
▶ However, the growth rate will gradually decline as the economy
approaches its steady state.
More on next lecture on Feb 08

▶ No lecture on Monday, Feb 05 - due to GATE exam duty.

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