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Endogenous Technological

Change

Paul M. Romer
Presented by Fanny Lemus
December 4, 2017

Introduction
We present a model created by Romer (1992) which describe an economy with
three sectors including a monopoly and a competitive firm with fixed values
of human and physical capital where the variables that growth at a constant
rate are: technology, capital, aggregate consumption and aggregate production.
Romer proved that all those variables growth at the same rate and that labor
has not effects in this rate. He also proved and compared the different rates
in a centralized and decentralized contexts. Then we made a little extension
making endogenous the level of Human capital instead of fixed but remaining
L constant where people has one unit of time that can be allocated between
increase their level of H or in their work as a research or a worker in the man-
ufacturing sector. We analyze both effects of the increase in H for individuals,
the first case is that people are more productive in the research sector ant the
second case, they improve their performance in the production sector. In the
first case we solve for a centralized context obtaining that in the limit, peo-
ple just spend their unit of time accumulating H and we gave some intuition
about the results. In the second case we obtain the same results as the origi-
nal model with an upper bond of H that is determined endogenously, that is,
at certain level of H people decide to spend all their unit in their respective jobs.

The argument for the author is based on three premises:


Technological change lies at the heart of economy growth.
Technological change arises in large part because of intentional actions
taken by people who respond to market incentives.
Instructions for working with raw materials are inherently different from
other economic goods.

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Figure 1

Since those premises are granted therefore, the equilibrium with price taking
firms can not exist instead of that, there is an equilibrium with a monopoly
intermediary firm.

Rivarly and Excludability


Economic goods have two principal characteristics, the level they are excludable
and the level they are rivalrous (Cornes and Sandler 1986). A good is rival if it
can be possesed or consumed by a single user; a non rival good is which when
a consumer can use it without prevent its use for another, those characteristics
are purely technological. The term: excludability is formed by both a legal
system and technology. A good is excludable is the owner can prevent its use
from others. Figure 1 shows many examples about the terms described above.
The case treated here for growth theory is with a set of goods that are nonri-
val yet excludable, this is, technology. The third premise refers that technology
is a nonrival input. The second premise refers that technological change takes
place because the own interest of the producers who make profits for every
unit of new designed created that is the partyally excludable part of it. The
first premise suggests growing driven by accumulation of non rival, partially
excludable input.

Description of the Model1


The model has four basic inputs: capital, labor, human capital and the level
of technology available at time t. Capital K is measured in units of con-
sumption goods. Each new unit of knowledge A corresponds to a design of a
new good. Labor L services are skills, they are measured by counts of people.
Human capital H corresponds to level of education and experience, is the prac-
tice in growth which changes the quality of the labor force.

The model separates the rival component of knowledge, H, from the nonri-
val technological component, A. Human capital can be provided and traded in
competitive market and it is bounded because people only live a finite numbers
of years and when they died, their skills also do. The scientific research that is
1 It is described as P. Romer does in his paper.

2
A lives on after the person is gone this for the non rival good, that is why A
can grow without bond.
The formal model of the economy has three sectors:
The research sector which uses human capital and the existing stock of
knowledge available to produce new knowledge.
An intermediate- goods sector which uses the designs from the research
sector together with forgone output to produce the large number of pro-
ducer durables that are available for use in final production at any time
and they do not depreciate. There is a distinct firm for each durable good
i, so there are not a representative intermediary firm.
A final good sector which uses labor, human capital and the set of producer
durables that are available to produce final output. Output can either
consumed or saved as new capital.
Assumptions used for simplifying the analysis:
Population and supply of labor are both constant. This rules out an
analysis on labor force participation, variation in hours worked per worker
and fertility. Total stock of human capital in the population is fixed and
that the fraction supplied to the market is also fixed.
Only knowledge and human capital are used to produce new designs or
knowledge, labor and capital do not enter at all.

Final Output
Final output Y is expressed as a function of physical labor L, human capital
devoted to final output HY and physical capital. The unusual feature of the
production technology assumed here is that it dis-aggregates capital into an
infinite number of distinct types of producer durables indexed by an integer i.
Only a finite number of these potential inputs have already been invented and
are available for use are any time. Due to A changes in the measure new designs
are invented, its important to include that in the production function.
A simple functional form for output is the following extension of the Cobb-
Douglas production function:

X
Y (Hy , L, x) = Hy L x1
i (1)
i=1

Because the production function is homogeneous of degree one, output int he


final-goods sector can be described in terms of a single, aggregate, price-taking
firm. The sector that produces durables, however, cannot be described as a
representative firm. There is a distinct firm for each durable good i. A firm
must purchase or produce a designs for good i before start production. Once it
owns the design, the firm can convert units of final output into one durable
unit of good i.
According with a model of one sector and for onvention with national income
accounting, capital evolves as

K(t) = Y (t) C(t) (2)

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Where C(t) denotes the aggregate consumption at time t. It is important to
remake that units of forgone consumption are used to create one unit of any
type of durable, with this, K is related with de durables that are actually used
in production by the rule

X A
X
K= xi = xi
i=1 i=1

Research Sector
The research sector produces new designs that once they are invented and pro-
duced can be used freely in the sector to create more knowledge and increase
the unbounded stock of designs, this is feasible because A is a nonrival input as
we described above. Growth in A increases the productivity of human capital
in the research sector. The output of research j is therefore H j A. Hence,
aggregating across all people, the aggregate stock of designs evolves according
to
A = HA A (3)
Where is a productivity parameter, HA is the proportion of H used in the
research sector and A is the knowledge available at the moment. It is important
to note that the higher is HA the higher is the rate of growth of production of
new designs.
The aggregate level of human capital is constrained by HA +HY = H, where
H is the fixed level of human capital devoted to individuals.
Let PA the price of new designs, let wH the rental rate per unit of human
capital and let r the rate of return for capital. Because the assumption of non
rival knowledge it follows that
Wh = PA A (4)

Intermediate-goods Sector
Once a design is produced, a large number of suppliers bid for the rights of
it. Each takes the price PA for designs, price of one for capital goods and the
interest rate as given. Therefore those firms set p(i) to maximize profits before
begins production.
Given values for HY and L, the aggregate demand for durables of the pro-
duction sector that maximize profits is:
Z
max [HY L x(i)1 p(i)x(i)]di.
x 0

Differentiating for x under the integral, leads to an inverse demand function:


p(i) = (1 )HY L x(i) (5)
The demand curve given by 5 is what intermediary sector takes as given to
maximize profits. Then, given HY , L and r the monopoly pricing problem is
= max p(x)x rx.
x
= max (1 )HY L x(i) x rx.
x

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Where x is the interest cost of output needed to produce x durables. The
firm has constant marginal cost that faces a constant elasticity demand curve.
Solving for ()

p(x) + p0 (x)x rx = 0
(1 )HY L x(i) + ( )(1 )x r = 0
(1 )HY L x(i) (1 ) = r
= r
p(x)
(1 )

Therefore, the monopoly profit is

r ( + )
= x rx = rx = px( + ) (6)
(1 ) (1 )

Where x is the quantity of x determined by p in equation (5).


Since the market of designs is competitive and the firms bid for the rights,
they will bid up until the price is equal to the present value of the net revenue
that a monopolistic can extract:
Z R

e t r(s)ds ( )d = PA (t) t (7)
t

If PA is constant as it will be in equilibrium, the equation below can be


differentiated with respect to time t as follows:
Z R

(t) r(t) e t r(s)ds ( )d = 0 (8)
t

Taking equation (7), we have

(t) = r(t)PA (9)

This equation says that in every period t, the profit of intermediary firms
must be equal to the cost of cover the interest cost of the initial investment in
design, this is called an intertemporal zero profit. 2 .

Consumers
Consumers preferences are given by a isoelastic function:
Z
C 1 1
U (C)et dt, with U (C) = f or [0, ] (10)
0 1
Consumers are endowed with fixed quantities of labor L and human capital
H which can be used either in the research sector HA or in the production
sector HY , both are supplied in-elastically. At time 0, consumers own the
existing durable-goods-producing firms, and the net revenues of these firms are
paid to consumers as dividends. Final-goods firms earn zero profits, so they can
be ignored in the specification endowments.
2 Taken from Grossman and Helpman 1989

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The equilibrium
The equilibrium in this model is such that:

i) consumers make savings and consumption decisions taking interest rates


as given;
ii) holders of human capital decide whether to work in the research sector or
the manufacturing sector taking as given the stock of total knowledge A,
the price of designs PA , and the wage rate in the manufacturing sector
wA ;
iii) final-goods producers choose labor, human capital, and a list of differen-
tiated durables taking prices as given;
iv) each firm that owns a design and manufactures a producer durables max-
imizes profit taking as given the interest rate and the downward-sloping
demand curve it faces, and setting prices to maximize profits;
v) firms contemplating entry into the business of producing a durable take
prices for designs as given;

vi) the supply of each good is equal to the demand.

Discussion of the model


As we described above the model is based on Solow (1956) and Uzawa (1965)
models with endogenous technology where the total stock of human capital is
allocated between a research sector or a manufacturing sector. Since A deter-
mines the level of durables produced x and since units of capital are required
per unit of durable goods. We show the output as

X
Y (HA , L, X) = Hy L xi1
i=1
= HY L Ax1
(11)
K 1
= HY L A
A
= (HY A) (LA) K 1 +1

We can note that the production function is a neoclassical function where human
capital has an effect in K and L. Given the preferences, the level of capital is
determined by the equality between its marginal product and its discount rate.
If A grows at a constant rate g, then K must grow at the same rate g due to
K = Ax. These result can be infered by the Solow model where K grows
at rate g + n where n is the rate of growth of labor L which in this case is 0.
Therefore, in the balanced growth path where all variables grow at a constant
rate, the ratio K/A, r and x are constant.

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Solution of the Model for a Balanced Growth
Path
Now, we will solve for a balance growth path where all variables must grow at
a constant rate but no necessarily at the same. Remembering the Solow model
where gK = gY = gC it suggests that if an equilibrium exists, A must grow at
a constant exponencial rate, but Uzawa model suggest that is possible for A to
grow at a constant exponencial rate duet to the linearlity of A in equation (3).
Once we can ensure that a balanced growth path exists, we disposed to solve
for all the variables. By the equation 3 it follows that the productivity in the
research sector also grows in proportion to A. The price for new designs needs
to be constant if we want HA and HY constant.

First of all,from the solution of the monopoly (equation 6) and since the price
of the design must be equal to the present discounted value that a monopoly
sector can extract, it follows that
1 + + 1
PA = = px = HY L x (12)
r r r
Where p and x is the price of the monopoly sector and the level of durables
determined by p respectively.
Then, the condition that determines the allocation of human capital between
both sectors is such that

wA = PA A = HY1 L Ax1 = wY (13)

This is, both wages must be the same and therefore the individual is indifferent
between the allocation of his human capital.

Then, combining equations (12) and (13) and simplifying and solving for
HY :
1
HY = r (14)
(1 )
Where

=
( + )
And for a fixed value of H, HY = H HA . For equation (3) it follows that

A
= HA = g
A
We saw in the last section that A A =
K
K = g. Then, for the resources
constraint (2) dividing by Y , the ratio

C K K
=1 (15)
Y KY
must be constant. Putting together the pieces of the puzzle, where g is the
common ratio of growth:

C Y K A
g = HA = = = = (16)
C Y K A

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Continuing with the solution for () and (43)

g = HA = H r (17)
(1 )
The maximization problem faced by the consumer with r as given, it follows
that
C (r )
= (18)
C
then, solving by r and substituting in the last equation, we have
H
g= (19)
+ 1
Thus, a result of the model is that as higher is the stock of human capital
H the higher is the rate of growth for all the variables. About intuition, note
that the opportunity cost of allocate the human capital in the research sector
is the wage earned in the manufacturing sector and the return to invest in the
research sector is the net revenue that a design generates in the future. It is
important to remark that the level of labor has no effect in the results, from the
monopoly problem the higher is L the higher is de demand for durables x and
a reduction in reduces the cost of the problem and increase profits it implied
that the price PA for a new design increases also. Although L and have
influence in PA , the level of H allocated in the research sector has no changes
contrarily with a classic model where an increase in the return of an activity
increase the allocation in the activity. To explain this effect, note also that an
increase in L or increase the productivity for HY in the manufacturing sector
thus raise the wage and Hy should increase, interestingly, both effects exactly
cancel and there no increase in Hy nor in HA . To conclude the results, from
equation (), where is the parameter that reflects the patient of the individuals
a decrease in this parameter can make that the economy growth at a higher rate.
For low levels of H stagnation may arise, growth does not take place matching
this with prehistoric time where there were a low level of H almost zero, and
growth were absent. Due to the positive externality caused by A, the author
solve the problem in a centralized context. We are going to show the results
and compared with those of the decentralized context.
Z 1
C 1 t
max e dt
C 0 1
subject to
K = (HY A) (LA) K 1 +1 C,

A = HA A,

HY + HA H

Where the solution for the rate growth is


H
g = (20)
+ (1 )

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Note that g > g where = 1 and this is because in a centralized
model, the externality is internalized by the social planner also, he term 1 is
replaced by (1 ) rising the allocation in the research sector and thus provide
a higher growth rate in the centralized model.

Extension, Part I
We all know that economic models just try to reflect the reality, that is why we
made a little modification of the paper presented above, taking human capital
as an endogenous variable instead of fixed. We present the same model adding
the accumulation of H.

The model
Individuals with isolastic preferences as equation (10) are endowed with an unit
of time which can be used either to grow their level of H or for work. Due to
people spend time (1-u) raising their level of human capital, they can be more
efficient as a researcher.3 Economy has three sectors as the original model:
research, intermediary and final-goods sector. There are three variables which
are endogenous and evolve as follows:

K = Y (t) C(t), A = AHA (1 u(t)),


H = Hu(t). (21)

Where and are productivity parameters. From now just for simplify
notation u(t)=u.The production function is the same as the original model,
equation (1). For simplicity we will solve the problem only in a centralized con-
text.

Thus, in order to derive the necessary conditions for the social optimization
problem given the structure, the current-valued Hamiltonian:

C 1
H: 1+[ +1 A+ (H HA ) L K 1 C]+AHA u+H(1u)
1
(22)

First order conditions for all t of the control variables

Consumption:
H
: C =
C
Differentiating both sides respect to time we have:

C
=
C
3 The next section we show the case where people are more efficient in the production sector

as a result of their investment in H.

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Human capital in the research sector:
H
: +1 A+ (H HA )1 L K 1 = Au
HA
Let = +1 A+ (H HA ) L K 1 . Then, the last equation is:
Au
= (H HA ). (23)

Portion of time u dedicated to work:


H
: AHA = H
u
H
= (24)
AHA

First order condition for all t of the state variables:

Capital
H
K: =
K

Where
H
= (1 ) (25)
K K
Then,

= (1 ) (26)
K
(27)

Technology

H
A: =
A

Where,
H
: ( + ) +1 A+1 (H HA ) L K 1 + HA u
A
Then,
( + )
= HA u (28)
A

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Human Capital
H
H: =
HA
Where,
H
: +1 A+ (H HA )1 L K 1 + (1 u)
HA
Then,

= (1 u) (29)
H HA

Plus, the transversality conditions:

lim K(t)(t)et = 0 (30)


t
t
lim A(t)(t)e = 0 (31)
t
lim H(t)(t)et = 0 (32)
t

Taking equation (26), dividing by and equalizing with (), we obtain

C
+ = (1 ) (33)
C K
From the resources constraint
K C
K = C =
K K K
Then
C K C
+ = (1 )( + ) (34)
C K K
Due to C K
C and K are constants it implies that the ratio
C
K is also a constant.
Taking logarithm and differentiating respect to t, then
C K
= =g
C K
From the description of the model where K = Ax, it implies that in the balance
growth path,
C
= = =
C
Substituting (23) and (24) in equations (28) and (30), we get the equation
systems:
u(H HA )
HA u = HA u (35)

H
u (1 u) = HA u (36)
HA

11
4
Where = + . Solving for HA in terms of u and u in terms of HA :

uH
HA = , u= (37)
u(1 + ) (HH

A)
+ HA + H
HA

Then, the rate of growth g of variables is given for:


uH
g = uHA = (38)
(1 + )

Taking the limit for the solution for u in terms of parameters of the model
when H grows:
lim u(H) = 0 (39)
H

Then, taking the limit of (38) when H , we obtain:

( )( 1 )
lim g(u(H), H, HA (H)) = (40)
H ( 1 + )

Which is the solution from a Balance Growth Path where all variables growth
at a constant rate. Lets discuss about this case of effect of u, where people
can be more productive in the research sector if they care about increase their
level of H, note that new designs A has effect directly in the intermediary sector
and an indirect effect in the manufacturing sector, both effects are positive, the
more designs are available in the economy, they can be used to produce new
technology at a higher level it implies that more durables are produced ant thus
the final output is higher. That is why people increase the fraction (1 u) for
the accumulation of H each period of time. We will try to justify this result
intuitively: Imagine that your occupation is create wooden articles, the first
time you do it will take you a certain time of hours, but you decide to spend
a fraction of your time learning new methods for your job and the rest of time
you work in your career. The more techniques you learn in order to reduce
the time creating new products, the less time you need to produce designs and
therefore the time spent producing tends to zero as H increase more amd more.5

Extension Part II
As a second part of the extension, instead of making more productive individuals
in the research sector, they are more efficient in the manufacturing sector. Thus,
the new production function for the final goods-sector is:

X
Y (Hy , L, x) = (Hy u(t)) L xi1
i=1

The three variables that evolve in time are:

K = Y (t) C(t), A = AHA ,


H = Hu(t). (41)
4 Due to the solution for u and HA is larger than we expected, it is included in the appendix.
5 We are supposing in this case that H are unbounded

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The preferences for the individuals are the same as the last two models. We
solve this model in two ways: centralized and decentralized context, well show
that the results for the variables g and g are the same as in the original model
where the added variable u tends to 0 as H increases. Finally well show the
principal results and also a comparison between those two contexts.

Solution in equilibrium
Due to the new variable u is present up to the production function, it does not
have effect neither the maximization for the monopoly sector nor for HY , this
is:
r
p(x) =
(1 )
and, the monopoly profit is:

= px( + )

Then,
wH = PA A = (42)
Which implies in equilibrium that:
1
HY = r (43)
(1 )

And the solution for g in equilibrium is:


H
g= (44)
+ 1
Solving the current-valued Hamiltonian

C 1
H: 1+[ +1 A+ (HHA ) u L K 1 C]+AHA +H(1u)
1
(45)

Obtaining the first order conditions from the control an state variables and
adding the transversality conditions, doing algebra for the interest variables, we
obtain the follow equations system:
Hu
(1 u) = HA (46)
H HA

(H HA ) HA = HA (47)

Solving for u and HA

H /
HA = (48)
1+
[/ + H( 1)][( 1) ( 1 + ) H]
u = (49)
(H /)( 1 + )

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How we are interested in the solution for u when H , with the help of
M athematica we take the limit:

lim u(H) = 0 (50)


H

Because u [0, 1], there exist a finite value of H such that u(t)=0 this is, at
that level of H people do not spend time accumulating human capital, maybe
because the return of investing an  part of u is zero, therefore, they prefer to
work with the highest level of human capital at that time.

Conclusion
As a conclusion, we expose the model created by Romer with technology en-
dogenous, making little changes about the exogeneity of human capital with
two different effects: in the research sector and in the manufacturing sector. We
conclude in the first case, that there exists certain level of H where people prefer
to spend all their time in their job instead of invest time increasing their level of
human capital as in the original model, and in the second case, we find a result
in the limit where unlike the first case, people only spend time accumnulating
human capital.

References
[1] Robert M. Solow A Contribution to the theory of Economic Growth 1956:
Quarterly Journal of Economics.
[2] Hirofumi Uzawa Optimum Technical Change in an Aggregative Model of
Economic Growth 1965: University of Pensilvania.
[3] Paul M. Romer Endogenous Technological Change 1990: University of
Chicago.

Appendix
The solutions of the system equations in (37) in terms of the model parameters
are given in the figure (2).
Solutions of the limits presented in equations (39) and (40) are showed in figures
(3) and (4).

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Figure 2

Figure 3

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Figure 4

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