Romer Model Slides

Macroeconomics 1
Endogeneous Growth model: Romer (1990)
Sargam Gupta
IGIDR
Fall Semester, 2023
Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 1 / 36

Endogenous Growth Models
David Romer: Chapter 3, 4

Daren Acemoglu: Chapter 13 and 14: (Ch- 13 introduces Romer
(1990))
Barro et al.: Chapter 4, 5 and 6
Chapter 4: AK Model
Chapter 5: Human Capital → R&D (Expansion of knowledge set);
Education Sector → Human capital accumulation
Chapter 6: Paul Romer (1990)

Introduction
Romer (1986) Increasing Returns and LR Growth, JPE

Learning by doing model
Knowledge spillover
Romer (1990) Endogenous Technical Change, JPE
Research and Development
Process innovation
Gross and Helpman (1991)- 2 papers
Research and Development
Product innovation
Aghion and Howitt (1992)
Endogenous Growth Model (book)
Creative destruction: When new technology comes up the old
technology becomes obsolete

Introduction: Romer (1990)
Model with expanding variety of inputs to production

Three important features of the model:
Ideas and technology are non-rival
Increasing returns to scale due to knowledge spillover: Although CRS
in inputs
Cost of R&D is a fixed cost
R&D private firms: → Profits incentives → Monopolistic
competition: P > MC (for example due to some patent in place)
Profits incentives → Monopolistic competition → P > MC unlike
perfect competition where P = MC

Model setup I
Type 1: Firm→ Final Output (Y) → Perfectly competitive setup.

For 0 i 0 th firm and 0 j 0 th research firm (discrete aggregator on varieties in
Barro) using Dixit-Stiglitz CES aggregates (1977)
N
X
Yi = AL1−α
i (Xij )α
j=1
DA: Continuous aggregator on variety

Z N
Yi = AL1−α
i (Xij )α dj
j=1
A: Measure of overall productivity; L: Labour input; N: No. of variety

of intermediate inputs
(Xij ): Specialised intermediary inputs →
Diminishing marginal productivity of each input, Li and Xij , and
constant returns to scale in all inputs together
Model setup II
Assumption of independence is important because it implies that
discoveries of new types of goods do not tend to make any existing
types obsolete
It is important to notice that technological progress takes the form of
expansions in N, the number of specialized intermediate goods
available, rather than increases in A
Type 2: R&D firm/ Intermediate input producing firms (Xj ) → j th
variety → Monopolistic competition
Suppose all are employed in the same quantity, Xij = Xi, the quantity of
output is then given from the equation by,
Yi = AL1−α
i N(Xi )α
Yi = AL1−α
i N 1−α (NXi )α

Model setup III
The production function has CRS in Li and NXi

N 1−α : Technological progress is arising from an increase in the
number of total intermediates, → R&D → Innovation goods
N (1−α) captures a form of technological progress as the benefit from
spreading a given total of intermediates.
The final goods, Yi , produced by all firms are physically identical.
All prices are measured in units of the homogeneous flow of goods,
Y . It is numeraire.

Final good’s firm optimization I
Maximize profits
N
X
πi = Yi − wLi − Pj Xij
j=1
Yi : Revenue P
N
Cost: wLi + j=1 Pj Xij
Labour: L Pj : Price for j th variety of input goods

Final good’s firm optimization II
Maximize profits with respect to Xij and Li

N
X
Yi = AL1−α
i (Xij )α
j=1
∂πi ∂Yi
= − Pj = 0
∂Xij ∂Xij
⇒
Aα 1−α
1
Xij = Li ( )
Pj
Xij : Demand for j th variety of input by i th firm

Final good’s firm optimization III
1
Demand for j th variety ∝ Pricej . Inverse demand function.
−1
Price elasticity of dd = 1−α
Labour demand equation
∂πi Yi
⇒ w = (1 − α)
∂Li Li

R& D firms/ Research firms
R&D firms face a two-stage decision process.

First, they decide whether to devote resources to invent a new design.
Firms expend these resources if the net present value of future
expected profits is at least as large as the R&D expenditures, which
are paid upfront. How much do you invest? Investment is profitable.
In the second stage, the inventors determine the optimal price at
which to sell their newly invented goods to the producers of the final
output.

Stage 2: Optimal Price I
The basic problem is that the creation of a new idea or design, say for
intermediate good j, is costly but could then be used in a non-rival way by
all potential producers of good j.
Non Rival → Exclusivity in production → Perpetual patent licenses
→ producing ’Innovation’
Consider an institutional setup in which the inventor of good j retains
a perpetual monopoly right over the production and sale of the good,
Xj , that uses his or her design.
The monopoly rights could be enforced through explicit patent
’No uncertainty’ → Stream of profits → R&D → successful and
innovation good is produced
Deterministic case → R&D investment is always successful protection
or through secrecy.

Optimal price II
PV of the returns from discovery of j th intermediate good:

Z ∞
V (t) = πj (v )e −¯r (t,v )(v −t) dv
t
1
Rv
where r¯(t, v ) = v −t t r (w )dw
r¯(t, v ): average interest rate b/n t and v
Assume that the marginal and average cost of production is a
constant, normalized to 1.
Profit flow is given by: Xj (v ): j th variety/j th R&D firm
πj (v ) = [Pj (v ) − 1]Xj (v )
1
Xij (v ) = [ PAα
P P
where Xj (v ) = i j (v )
] 1−α Li

Optimal Price III
Xj (v ): Dd for j th variety by all firms

P
Li = Aggregate Labour input = L → constant (no population
growth)
Maximize the profit function to get optimal prices, Pj (v )
Optimal prices are,
1
>1
Pj (v ) =
α
The price is the constant and same for all goods j because the cost of
production is the same for all goods, and each good enters
symmetrically into the production function in equation.

Aggregates I
Aggregate quantity produced for each j th good

1 2
Xj = A 1−α α 1−α L
Aggregate quantity produced by all research firms
X = NXj
⇒
Yi = AL1−α
i N 1−α (NXi )α
Aggregating ∀i
Y = AL1−α N 1−α X α
Further simplifying,
1 2α
Y = A 1−α α 1−α LN
Aggregates III
Profit flows,
1 1 − α (1−α)
2
πj (v ) = LA 1−α ( )α
α
profit is constant over time
Net present value of the profit streams,
Z ∞
V (t) = π e −¯r (t,v )(v −t) dv (1)
t

Decision to enter R&D business
V (t) > R&D cost

η is the fixed cost of R&D
It is assumed that the total number of ideas is limited.
Cost of creating a new variety depends on the number of varieties
previously invented, η(N)
Two opposite forces acting her when new discovery is made,
The tendency to run out of new ideas suggests that the cost would rise
with N so that η 0 (N) > 0.
But if the concepts have already been discovered make it easier to
come up with new ideas, the cost could fall with N so that η 0 (N) < 0
would apply.
Assume these two effects cancel each other such that η is constant.

Decision to enter R&D business II
v (t) = valuation of the R&D project (today) → PV

η = cost you incur (today)
When v (t) > η → decide to invest→ infinite flow of resources
When v (t) < η → do not invest
Equilibrium only when v (t) = η
Thus v (t) = η for all t, this is also known as free-entry condition
Using Leibniz’s rule, we R vdifferentiate the free-entry condition, also use
1
(1) and r¯(t, v ) = v −t t r (w )dw

Decision to enter R&D business III
π v̇ (t)
r (t) = + (2)
v (t) v (t)
Interpretation: The R&D rate of return equals the profit rate, π/V (t),
plus the rate of capital gain or loss derived from the change in the value of
V (t) ˙
the research firm, V (t) . Since η is constant, the free-entry condition
˙
implies V (t) = 0, r (t) = r = πη . Substitution the value of profit we get,
1 1 − α (1−α)
2
r = (L/η)A 1−α ( )α
α
The aggregate market value of firms is ηN

Households I
Each household maximizes utility over an infinite horizon

Z ∞ 1−θ
c − 1 −ρt
U= ( )e dt
0 1−θ
Households earn the rate of return r on assets and receive the wage
rate w on the fixed aggregate quantity L of labor.
The households’ aggregate budget constraint is,
ȧt = wt Lt + rt at − Ct
wt Lt + rt at : Inflow of income = Labour Y + Interest Y

No population growth

Households optimization
Consumption for all households C = Lc

Households optimization would give the following Euler’s equation
(since L is constant),
ċ Ċ 1
= = (r − ρ)
c C θ
Total assets of R&D firms: ηN(t) = a(t) → η Ṅ(t) = ȧt

General Equilibrium I
Simplifying the model further,

1 We know that 1 2α
Y = A 1−α α 1−α LN (3)
and
L 1 1 − α 2
r = ( )A 1−α α (1−α)
η α
2 This would imply,
1 Y
rt = ( )(1 − α)α( )
η N
3
Y
wt = (1 − α)
L
4 Total income at HH level
Y − α2 Y (4)
General Equilibrium II
5
η Ṅt = wt Lt + rt at − Ct
6
η Ṅt = Yt − α2 Yt − Ct
7 Economy-wide resource constraint
Yt = Ct + α2 Yt + η Ṅt
Supply: Yt ; Demand: Ct + α2 Yt + η Ṅt

Yt : Total output (Total Reserve)
Ct : Consumption
α2 Yt = Xt : Production of intermediates
η Ṅt : Creation of new varieties of innovation good
General Equilibrium III

Note
(Ceteris paribus) When α increases → more resources towards producing
innovation goods
When η is higher → more resources towards R&D (This is because
V(t)=η, i.e. present value of the stream of profits with innovation)
The level of the output depends on the growth of R&D firms
(endogeneity).
Y =C +I +G
Yt = Ct + Xt + η Ṅt
ċ 1
= [r − ρ]
c θ
General Equilibrium IV
substitute for
L 1 1 − α (1−α)
2
r = ( )A 1−α ( )α
η α
ċ 1 L 1 1 − α 1−α
2
γ= = [( )A 1−α ( )α − ρ]
c θ η α
Assumption
Parameter restrictions are such: γ ≥ 0 such that the R&D firms grow over
time. γ = f (α, ρ, θ, A, L, η)
BGP
No transitional dynamics

Rate of growth
Using equation (3) we can say that
Ẏ Ṅ
=
Y N
Rewriting the economy-wide resource constraint equation,
Ct = Yt − α2 Yt + ηγNt
where ηγNt = η Ṅt

Substituting for Y in the above equation,
C = (N/θ){LA1/(1−α) (1 − α)α2α/(1−α) [θ − α(1 − θ)] + ηρ}
This implies
Ċ Ṅ
=
C N
Thus the rate of growth of Y , C and N is the same, γ.
Scale effect
All three growth rates are a function of L. The model contains a scale
effect in that a larger labor endowment, L, raises the growth rate, Y .
The present model has a scale effect because a new product, which
costs η to invent, can be used in a non-rival manner across the entire
economy.
The larger the economy-represented by L—the lower the cost of an
invention per unit of L (or Y ). Therefore, as with a decrease in η, an
increase in L raises Y .
High population growth → high growth rates. Jones (1999) criticized
Romer model for its scale effects

Social Planner’s problem: Pareto Optimality
The social planner will maximize the following utility function,

Z ∞ 1−θ
c − 1 −ρt
U= ( )e dt
0 1−θ
subject to the economy-wide resource constrainYt = Ct + η Ṅt + Xt

Social Planner’s problem II
Re-writing the constraint,

1
Ṅt = [AL1−α Nt1−α Xtα − Ct − Xt ]
η
Optimal control problem → Ct
Ct (HH) → control variable
Xt (Firm type 2) → control variable
Nt → state variable → Price of Nt is vt

Social Planner’s problem III
Present Value Hamiltonian

1
H = U(Ct )e −ρt + vt ( )[AL1−α Nt1−α Xtα − Ct − Xt ]
η
1
H = U(Ct )e −ρt + vt ( )[AL1−α Nt1−α Xtα − ct L − Xt ]
η
with Ct , Xt = controls Nt = state

Social Planner’s problem IV
Sufficient conditions for optimal solutions:

∂Ht
1
∂Ct =0
1
U 0 (Ct )e −ρt − vt ( )L = 0
η
∂Ht
2
∂Xt =0
1
vt ( )[αAL1−α Nt1−α Xtα−1 − 1] = 0
η
∂Ht
3
∂Nt = −v̇t
1
vt ( )[(1 − α)AL1−α Nt−α Xtα ] = v̇t
η

Social Planner solution I
Simplifying the first-order conditions further,

1 First optimizing condition
1
U 0 (Ct )e −ρt − vt ( )L = 0
η
ηU 0 (Ct )e −ρt
vt =
L
dvt η dU 0 (Ct ) −ρt

= v̇t = [ e − ρU 0 (Ct )e −ρt ]
dt L dt
η −ρt ∂Ct )
v̇t = e [U”(Ct ) − ρU 0 (Ct )]
L ∂t

Social Planner solution II
2 Second optimizing condition,

1 1
Xt = A 1−α α 1−α LNt
3 Combining first and third conditions,
Ċt 1 1
= [( )(1 − α)AL1−α Nt−α Xtα − ρ]
Ct θ η
(use − U”(C t)
U 0 (Ct ) Ct = θ )

Social Planner II
Social planner solutions
1 1
Xt∗∗ = A 1−α α 1−α LN
Ċt 1 L 1 1 − α 1−α
1
γ ∗∗ = = [( )A 1−α ( )α − ρ]
Ct θ η α
1 α
Yt∗∗ = A 1−α α 1−α LN
Decentralized Solutions
1 2
Xt∗ = A 1−α α 1−α LN
1 L 1 1 − α 1−α
2
γ ∗ = [( )A 1−α ( )α − ρ]
θ η α
1 2α
Yt∗ = A 1−α α 1−α LN
Social Planner III
1 1
Xt∗ = α 1−α Xt∗∗ ⇒ α 1−α < 1 ⇒ Xt∗ < Xt∗∗
α α
Yt∗ = α 1−α Yt∗∗ ⇒ α 1−α < 1 ⇒ Yt∗ < Yt∗∗
1 1
γt∗ and γt∗∗ ⇒ α 1−α ⇒ α 1−α < 1 ⇒ γt∗ < γt∗∗
1
Pj∗ =
> 1; Pj∗∗ = 1
α
(1 − α) 1/(1−α)
r ∗∗ = (L/η)A1/(1−α) α > r∗
α

Summary
The Romer model is able to explain the growth in macroeconomic

variables including Y , C and I in the model with no population
growth and no technological growth.
The Social planner economy gives Pareto optimal solution while the
decentralized economy gives a sub-optimal one.
The government could induce the private sector to attain the social
optimum in a decentralized setting if it could engineer a tax-subsidy
policy.
Subsidies to Intermediate goods, to final goods, or to the Research
and Development are some examples.

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Macroeconomics 1

Endogeneous Growth model: Romer (1990)

Fall Semester, 2023

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 1 / 36

Endogenous Growth Models

David Romer: Chapter 3, 4

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 2 / 36

Romer (1986) Increasing Returns and LR Growth, JPE

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 3 / 36

Introduction: Romer (1990)

Model with expanding variety of inputs to production

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 4 / 36

Type 1: Firm→ Final Output (Y) → Perfectly competitive setup.

DA: Continuous aggregator on variety

A: Measure of overall productivity; L: Labour input; N: No. of variety

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 6 / 36

Model setup III

The production function has CRS in Li and NXi

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 7 / 36

Final good’s firm optimization I

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 8 / 36

Final good’s firm optimization II

Maximize profits with respect to Xij and Li

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 9 / 36

Final good’s firm optimization III

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 10 / 36

R& D firms/ Research firms

R&D firms face a two-stage decision process.

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 11 / 36

Stage 2: Optimal Price I

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 12 / 36

PV of the returns from discovery of j th intermediate good:

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 13 / 36

Optimal Price III

Xj (v ): Dd for j th variety by all firms

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 14 / 36

Aggregate quantity produced for each j th good

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 16 / 36

Decision to enter R&D business

V (t) > R&D cost

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 17 / 36

Decision to enter R&D business II

v (t) = valuation of the R&D project (today) → PV

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 18 / 36

Decision to enter R&D business III

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 19 / 36

Each household maximizes utility over an infinite horizon

wt Lt + rt at : Inflow of income = Labour Y + Interest Y

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 20 / 36

Consumption for all households C = Lc

Total assets of R&D firms: ηN(t) = a(t) → η Ṅ(t) = ȧt

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 21 / 36

Simplifying the model further,

Supply: Yt ; Demand: Ct + α2 Yt + η Ṅt

General Equilibrium III

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 25 / 36

where ηγNt = η Ṅt

C = (N/θ){LA1/(1−α) (1 − α)α2α/(1−α) [θ − α(1 − θ)] + ηρ}

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 27 / 36

Social Planner’s problem: Pareto Optimality

The social planner will maximize the following utility function,

subject to the economy-wide resource constrainYt = Ct + η Ṅt + Xt