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Romer’s Economic Model of Growth

In 1990 Paul Romer through his paper “Endogenous Technological Change,” Journal of
Political Economy, changed the world view of growth using information technology – shifting
the focus of economics away from the traditional productive factors, namely, land, labour and
capital, towards “people, ideas and things”. His model fell under the new endogenous growth
theories which depicted long-run growth rate of an economy on the basis of endogenous factors
as against exogenous factors of the neoclassical growth theory. Where primary focus of the
neoclassical growth model is on the growth of productive inputs, Endogenous Growth Theories
adds to this a more developed treatment of the process of innovation. The Romer model is one
which drifted from the conclusion of the neoclassical model of Solow, who concluded that
technological change was a key driver of economic growth and however made the factor
exogenous to the model. That is, technological change was not something determined in the
model but was an outside factor. Romer made it endogenous.

Within this model the main determinant for growth is technological change. It focuses on the
distinction of objects and ideas, with the other productive factors such as capital and labor and
their impact on output. As such stipulates that output requires knowledge and labor with a
Research sector in the market specializing in the production of ideas. This sector invokes
human capital along with the existing stock of knowledge to produce ideas or new knowledge.

As such to depict this model, there are several assumptions to be expected for this model with
Economic growth from technological change.
 Technological change is endogenous.
 Market incentives play an important role in making technological changes available to
the economy.
 Knowledge or a new design is assumed to be partially excludable and retainable by
the firm which invented the new design.
 Technology is a non-rival input.
 Constant returns in Objects and increasing Returns in Ideas
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The Romer model focuses on the distinction between ideas and objects the assumptions of
the model, yields four equations, where x, L, l, are parameters of the variables.

Let Y= Output
L= Labour
A= Knowledge

 Producing output requires knowledge and labor.

Yt = At Lyt

This function of Output (y) which showcases that the production function has constant
returns to scale in objects alone but increasing returns to scale in objects and ideas.

 New ideas depend on the existence of ideas in the previous period, the number of
workers producing ideas, and their productivity.

At +1 = zAt Lat

 The number of workers producing ideas and the number of workers producing output
sums to the population.
Lyt + Lat = L

 Some fraction of the population produces ideas.

Lat = lL

Using these equations which fall under Romer’s model we can now solve to see its
relationship with growth.

 Yt = Yt = At Lyt = At (1-l)
L L
Output depends on the Stock of Knowledge

 At+1 = zLat = zlL

At
The Growth of Knowledge is constant,

 At = A0 (1+g)t
Stock of Knowledge depends on its initial value and its growth rate

Given these equations associated with the model, we will see how growth is achieved. In the
Solow model, capital has diminishing returns, which is eventually only enough to offset
depreciation on capital. Capital has diminishing returns alone because labor and capital have
constant returns together. This implies that capital and income stop growing. The Romer model
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does not have diminishing returns to ideas because they are nonrival. This means that labor and
ideas have increasing returns together and the returns to ideas are unrestricted. Growth the long
run of The Solow model exhibits transition dynamics because the growth rate declines the
closer the economy moves to steady state, but the Romer model does not exhibit transition
dynamics. The Romer model has a balanced growth path – on which the growth rates of all
endogenous variables are constant. Unless parameters of the model change, the economy has
constant growth due to its use and inclusion of technological factors into the model
endogenous.

Practically all countries in the world benefit from new ideas, even if they are created in another
country. As such The Romer model is best viewed as a model of the world. However, there are
some restriction for its use as a model particularly for lesser development countries. It is based
on many traditional neoclassical assumptions which are not applicable in case of Under-
developed Countries. As, here it has been assumed that there is a single production sector, or
all the industries are alike. Under-developed Countries the economic growth is also affected
by weak infrastructure, inadequate institutional setup and ineffective capital and goods
markets. As the Endogenous Growth Theory ignores such factors concerned with the
determination of long run growth rate whereas as far as developing countries are concerned, it
is more important for them to determine the short term and medium-term growth rate

The total stock of ideas is the key to sustained growth of per capita output due to its nonrivalry
characteristic diminishing returns is avoided and this allows growth to be constant. Considering
that many lesser developed countries have had a growth experience that was very far from the
conditions of this steady-state, it is of great importance for policy makers of lesser developed
countries to find out the factors and aspects contribute to low growth.