Macroeconomics

Nobel laureate Paul Romer’s contribution to endogenous growth theory

  • Blog Post Date24 October, 2018
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Mausumi Das

Delhi School of Economics

mausumi@econdse.org

What motivates people like Steve Jobs to spend time, money, and effort in developing new ideas despite the implicit hazard that ideas can easily be copied later? In this post, Mausumi Das contends that Nobel Laureate Paul Romer was the first economist who addressed this issue in a comprehensive manner and linked the economics of ideas to the economics of growth within a coherent macroeconomic framework.  

 

Technological progress lies at the heart of modern growth process. Living in this era of technological revolution, we have already witnessed the immense power of technology and the impact it has on people’s standard of living. It allows us to save effort, perform the same job better and faster, derive pleasure from activities that were not hitherto possible. While evidences of technological progress abound, it is not easy to explain why or how this has happened. What made Steve Jobs and Steve Wozniak come up with the first Apple product that eventually revolutionised the world of personal computers? Was it by chance or by design? If the latter, were they motivated by philanthropy or opportunities to earn profit? Looking back at the vast empire of Apple Inc. today, it is difficult to believe that the motive was anything but profit. But profits from experimenting with novel and innovative ideas are not guaranteed. Ideas – unlike any other input in production – are easy to steal. While it is costly to develop an idea into a marketable product, it can later be easily copied without spending the prerequisite time, effort and resources (as Steve Jobs was painfully aware of). Given this implicit hazard, what then explains the continuous proliferation of newer products that has completely transformed our day-to-day lives? Paul Romer was the first economist who addressed this issue in a comprehensive manner and linked the economics of ideas to the economics of growth within a coherent macroeconomic framework. This year’s award of the Sveriges Riksbank Prize in Economic Sciences (also known as the Nobel Prize in economics) to Paul Romer is in a sense a celebration of the economics of ideas, a celebration of technological progress itself. 

Until recently, mainstream (neoclassical) growth theory had an uneasy relationship with technological progress. Robert Solow’s seminal paper in 1956, which defined the contours of neoclassical growth theory, recognised the importance of technological progress in the growth process, and yet assumed it to happen automatically over time, like ‘manna from heaven’.  There were some early attempts to open up this black box (notably, by Arrow (1962) and Frankel (1962)). These works postulated that technological progress was an outcome of “learning by doing”. As workers operate with a set of machines, they gain experience and learn on the job, which make them more productive over time. More machines imply greater familiarity and therefore faster learning. Thus technical progress was seen as an unintended by-product of the capital accumulation process itself. Neither of these approaches however could explain why people like Steve Jobs would spend time, money and effort on their own to develop new ideas. 

Knowledge creation and long-run economic growth

In 1986, exactly 30 years after the publication of Robert Solow’s seminal work, an article appeared in the Journal of Political Economy, written by Paul Romer, then a young faculty at the University of Rochester. The title of the article was “Increasing Returns and Long-Run Growth”. At first glance, the article seemed a simple extension of the neoclassical framework incorporating production externalities – along the lines of Arrow, Frankel and others. Yet, a closer look would reveal an altogether different approach towards analysing and interpreting the mechanics of economic growth that was contrary to the neoclassical approach, a paradigm shift. Three features set it apart from the earlier body of work: (i) its emphasis that knowledge is an essential input in the production process; (ii) that new knowledge is produced by deliberate research and development (R&D) activities undertaken by private agents; it is neither an unintended by-product of capital accumulation, nor a manna from heaven; and (iii) that knowledge by its very nature is non-rivaland only partially excludable2. It is this last feature that drives growth in Romer (1986)

Once new knowledge is created, it cannot be kept completely under lock and key. Others can use it freely and benefit from it as much as its original creator. Thus each act of knowledge creation is associated with positive externalities: it enhances the overall productivity in the economy beyond the marginal benefit that accrues to its creator. In other words, each unit of knowledge has a positive spillover effect on the aggregate economy. And as more knowledge is created, the spillover effect becomes stronger, thus generating increasing returns to knowledge accumulation at the aggregate level and paving the way for perpetual long-run growth as well as possible divergence. Indeed Romer’s 1986 paper is one of the earliest attempts at explaining diverging growth patterns across different countries based on knowledge accumulation and associated spillover effects. In poorer economies, characterised by low stock of knowledge capital, marginal return to new knowledge creation would also be low. Private agents in these countries therefore would not have enough incentive to invest in R&D activities, resulting in stagnation and perpetuation of poverty. Opposite would be true in relatively advanced economies with an extensive base of pre-existing knowledge capital. These latter countries would therefore experience perpetual growth at an increasing rate. This particular conclusion of Romer (1986) directly contradicts the convergence hypothesis of the neoclassical growth theory which predicted that poorer economies would grow faster and eventually catch up with their richer counterparts. 

Romer’s proposed theory of long-run growth challenged several other conventional wisdoms associated with the neoclassical growth theory. One major difference arose from their contrasting views about the desirability and efficacy of government policies. Neoclassical growth models are founded on the premises of perfect markets and rational agents, which preclude any role of the government in influencing long-run growth. Romer on the other hand advocated for a proactive government policy. In the presence of externalities, market return to knowledge creation would differ from its social return which, according to Romer, necessitates government intervention. The role of the government in this context would entail creating the right incentives for private agents to engage in research. 

Profit-driven private endeavours and sustained technological progress

Despite its initial promise, Romer’s 1986 paper did not fully exploit all the distinctive features of knowledge creation. In particular, it paid scanty attention to perhaps the most significant aspect of knowledge creation, namely that it is an outcome of private initiatives. Private agents operate on profit motives. Yet monopoly profits from knowledge creation cannot be sustained under perfect competition. The primary shortcoming of Romer (1986) was that it could not completely break away from the neoclassical tradition: it retained the assumption of a perfectly competitive market structure. This implied that private initiatives in knowledge creation would not be fully rewarded either at present (due to externality) or in future (competition ruled out any scope for future profits). As a consequence, growth happens in Romer’s 1986 model purely due to the spillover effects that impact the aggregate economy, but are not internalised by the private firms, much like Arrow’s learning-by-doing model. In fact, the difference between the two then becomes a matter of semantics. The line of argument linking profit-driven private endeavours to technological progress, which was initiated in Romer (1986) but left somewhat unexplored, was finally brought to a closure in a follow-up paper of Romer that introduced imperfect competition, thereby allowing private firms to earn monopoly profits from knowledge creation. 

In 1990, another article by Paul Romer appeared in the Journal of Political Economy. The title of this new article was “Endogenous Technological Change”. In this paper, Romer modelled technological innovations and knowledge creation in the form of expanding varieties of new products. New ideas would translate into new products. Each such product would be produced by a monopolist producer who had incurred a fixed R&D cost in developing a particular variety and held the patent right over production of that variety. Patenting made knowledge creation excludable and ensured the existence of monopoly profits over long run. This in turn created incentives for private firms to engage in costly R&D activities that generated newer varieties. At the same time, knowledge being non-rival in nature, existing stock of knowledge could be readily used by potential producers of newer varieties. Long-run growth happened in this model due to gains from specialisation (through introduction of newer varieties) as well as spillover effects in research that effectively reduced the marginal cost of new innovations.

A major contribution of Romer’s 1990 paper was to seamlessly embed the ideas of increasing returns and imperfect competition3 into a micro-founded dynamic general equilibrium model of growth. To be sure, product variety models set in a monopolistically competitive market structure made their appearances in the literature before (for example, Spence 1976, Dixit and Stiglitz 1977, and Ethier 1982). But to integrate this framework to a decentralised, market-driven mechanism of innovation and knowledge creation that could endogenously explain sustained technological change was a remarkable achievement indeed. These articles by Romer paved the way for a new direction of research in growth theory, termed the “endogenous growth theory”.  

Policy implications of Romer’s work

Romer’s work on the knowledge economy and the process of innovation has also opened up new horizons in policy analyses. By directing our attention towards the role of private initiative in technological innovations and inventions, and the concomitant incentive issues, Romer has brought to the fore a tension implicit in modern technology-driven growth process. One the one hand, some degree of monopoly power is essential to induce private agents to engage in costly R&D activities. On the other hand, any monopoly power essentially entails an efficiency loss. In this context, designing the optimal government policy itself is a challenging issue. Indeed much of the recent policy debates on intellectual property rights, patents and their long-run implications can be traced back to Paul Romer’s work on endogenous technological progress.  

Given the long-lasting impact of Romer’s work on the subsequent theoretical, empirical and policy discussions on economic growth and its sustainability, the decision of the Royal Swedish Academy to award the Nobel Prize in economics to Paul Romer this year does not come as a surprise. The timing of the award is curious though. Romer’s alternative paradigm appeared exactly 30 years after the publication of Solow’s classic work on neoclassical growth theory. Perhaps it is befitting that the Nobel Committee took roughly the same time to recognise Romer’s contribution to growth theory after they recognised the contribution of Solow in 1987.    

Notes:

  1. Non-rival goods are those which can be consumed by one party without reducing the utility/ability to use by another. 
  2. Excludable goods are those goods where it is possible to prevent people who have not paid for it from having access to it.
  3. Markets are imperfect in nature – where barriers to the flow of information prevent a state of perfect competition. These include monopoly (single seller), oligopoly (few large sellers), monopolistic competition (many sellers with highly differentiated products) etc. 

Further Reading

  • Arrow, Kenneth J (1962), “The Economic Implications of Learning by Doing”, Review of Economic Studies, 29(3): 155–173. Available here.
  • Dixit, Avinash K and Joseph E Stiglitz (1977), “Monopolistic Competition and Optimum Product Diversity”, American Economic Review, 67(3): 297–308. Available here.
  • Ethier, Wilfred J (1982), “National and International Returns to Scale in the Modern Theory of International Trade”, American Economic Review, 72(3): 389–405.
  • Frankel, Marvin (1962), “The Production Function in Allocation and Growth: A Synthesis”, American Economic Review, 52(5): 995–1022. Available here.
  • Romer, Paul M (1986), “Increasing Returns and Long-Run Growth”, Journal of Political Economy, 94(5): 1002–1037. Available here.
  • Romer, Paul M (1990), “Endogenous Technological Change”, Journal of Political Economy, 98(5): 71–102. Available here.
  • Solow, Robert M (1956), “A Contribution to the Theory of Economic Growth”, Quarterly Journal of Economics, 70(1): 65–94. Available here.
  • Spence, Michael (1976), “Product Selection, Fixed Costs, and Monopolistic Competition”, Review of Economic Studies, 43(2): 217–235. Available here.
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