Professor F.

Demers
ECON 5002 Handout No.5
Carleton University, Winter 2011

1 Optimal Endogenous Growth

Assume that the economy is decentralized, as before. We have seen from that model that c; k; and y
are all constants in the steady-state. This implies that in the steady-state c; k; y all grow at the rate
of zero, or alternatively, that C; K; Y grow at the rate n: In the absence of technological progress, the
economy would converge to a steady-state with zero per-capita growth. This result is due to diminishing
returns to capital that are embodied in the neoclassical production function.
One way to overcome this problem is to broaden the concept of capital to include human capital,
and then assume that diminishing returns do not apply to this broader class of capital.
Another point of view is that technological progress in the form of "generation of new ideas" is the
only way that the economy can escape from diminishing returns. Therefore, if this is the only way, then
it becomes very important to analyze technological progress and to explain it within the growth model,
rather than as an exogenously speci…ed variable.That is, it is important to treat technological progress
as an endogenous rather than as an exogenous process.

1.1 A Simple Endogenous Growth Model: The AK Model

1.1.1 Households

Assume that households behave as before (as in the decentralized model without a government and
without technological progress.). Each household maximizes the discounted sum of all current and
future utilities, given as before by U :
Z 1
t
U= u(c(t))e dt (1)
0

where
c1t
u(c(t)) = (2)
1
subject to:
a_ = ra + w c na (3)
and the no-Ponzi game condition :
Rt
[r( ) n]d
lim fat e 0 g=0 (4)
t+1

The dynamic equation was found as

c_t 1
= [rt n ]
ct
where is the inverse of the elasticity of intertemporal substitution.

1.1.2 Firms

We assume perfectly competitive …rms which maximize pro…ts. Let

Yt = AK (5)

where Yt is the output level, and A > 0 is a productivity parameter. Here Kt is viewed as encompassing
not only physical capital but also human capital, human knowledge, public infrastructure, etc that
facilitate or improve production. In this framework all "labour" is augmented by human capital. There
is no "raw" or unskilled labour. We can expresss the production function in per capita terms as:

yt = Akt (6)

This production function violates the Inada conditions. In particular,

lim f 0 (k) = A (7)

k!1

The marginal product of capital is not diminishing. This is the key element that leads to endogenous
growth.
The …rst order condition for the …rm requires that

f 0 (k) = r +

where 0 < < 1 is the rate of depreciation. Since f 0 (k) = A; we have

r=A

Here since fL = 0; i.e., the marginal product of labour is zero, so that w = 0 as well. We can think of
w as being the payment to unskilled labour. Households get all compensation in the form of returns to
the broader notion of capital.

2
1.1.3 Equilibrium

As before, all debts cancel in equilibrium in a closed economy (net debt is zero), so that at = kt ; assets
per household equal capital per household. We also let w = 0: We …nd the resource constraint for the
whole economy as:
:
k = f (k) c (n + )k (8)
:
k = (A n) k c (9)

From the household’s problem, replacing r = A

c_t 1
= [rt n ]
ct
c_t 1
= [A n ] (10)
ct

This system with the initial condition k0 and the transversality condition determine the time paths
of c and k:1
Note that in this model unlike the exogenous optimal growth model, consumption is not a function
c_ t
of k:2 Hence there is no c_ = 0 equation. We assume that A > + n so that ct > 0:Therefore, as
long as this condition is satis…ed, we will have continuous growth in c:3
Now, to obtain the growth rate of capital, divide (8)by k :
:
k c
= (A n) (12)
k k
c
or, solving for k;

c k
= (A n) (13)
k k
1 The transversality condition is given by
n o
[A n]
lim k (t) e =0
t!1

2 That is, if we solve the di¤erential equation for consumption, we …nd the following expression
1 [A n]t
c (t) = c (0) e (11)

which is not a function of k:

3 However, we also need the following condition in order to satisfy the transversality condition and to have bounded

utility
A> +n+ > (A ) (1 )+ n+

3
 k
First note that in the steady-state all variables grow at constant rates which implies that k is constant
c
so that k is constant. This implies that
c k
= (14)
c k
Using equations (11) ; (8) and the transverslity condition, we can …nd that:

ct = 'kt (15)
k c 1
= = (A n) (16)
k c
4
where ' is a positive constant The determinants of growth are: ; A; ; n and : In addition since
y = Ak
y k
= (18)
y k
The model has no transitional dynamics.All variables, k; c; y are growing at the same constant rate
starting from k0 ; c0 = 'k0 ; and y (0) = Ak0 :

1.1.4 The Phase Diagram

There is no c = 0 locus. The k = 0 locus has a positive slope through the origin with slope A n:
The saddle path is a straight line through the origin with slope ': The slope of the saddle path is
smaller than the slope of the k = 0 locus.
Take a c0 above the saddle path. c will eventually reach 0: This violates the Euler equation. Take c0
below the saddle path. Then c and k grow without bounds and k grows faster. This violates the TVC.
The economy has to be on the saddle path.

1.2 Romer’s Model of Endogenous Growth

Households behave as in the above model.

Let us extend the decentralized growth model to introduce an externality associated with capital
accumulation.Let the total number of …rms in the economy be N (a large number). Let Ki be the
capital held by …rm i:We let
Yi = F (Ki ; Ai Li ) (19)
4 The value of ' is given by
1
' (A n) (A n) > 0: (17)

' is smaller than (A n) :

4
where Ai is an index of knowledge available to the …rm. A does not grow at an exogenous rate. De…ne
the aggregate capital stock as
N
X
K= Ki (20)
i=1

The aggregate labour force L is assumed to be constant (no population growth). We make two as-
sumptions: (a) Each …rm’s net investment leads to "learning by doing." That is, an increase in a …rm’s
capital stock leads to a parrallel increase in its stock of knowledge Ai : (b)Each …rm’s knowledge is a
public good that may be accessed by other …rms at a zero cost. Once discovered, a piece of knowledge
spills over instantly across the entire economy. Hence, given this assumption, we can write

A_ i K_ (21)

Therefore, the production function of …rm i becomes

Yi = F Ki ; KLi (22)

If K and Li are constant, then …rm i faces diminishing returns to capital as in the usual model. However,
as each …rm expands Ki ; this leads to an increase in the aggregate capital stock K: In turn, this provides
a spillover e¤ect that bene…ts all other …rms and raises their productivity. We may write the production
function in Cobb-Douglas form as follows:

1
Yi = Ki KLi (23)

Hence, …rm i0 s production function exhibits constant returns to scale in Ki and K for given Li . Let us
write yi = Yi =Li ; ki = Ki =Li and k = K=L: Since all …rms are identical, we can drop the i subscript,
so that yi = y and ki = k.
1
y=k K (24)

or equivalently
1
f k; K = k K (25)

or, letting K = Lk; we have

f (k; Lk) = k (k 1 L1 ) (26)

= kL1 (27)

Note that the average product of capital (and the marginal product of capital) is simply L1 which
is not a function of k:This expression gives us the "social" marginal product of capital. The "private"

5
marginal product of capital is found as
1
@(ki K )
f1 k; K = holding K cons tan t (28)
@ki
1 1
= ki K (29)
1
= k L1 k1 sin ce ki = k (30)

= L1 (31)

Hence, the private marginal product is smaller than the "social" marginal product, since L1 <
L1 since 0 < < 1: This means that the solution to the social planner’s problem will not coincide
with that of the decentralized model. For the decentralized model we get

c_ 1
= L1 (32)
c

while the planner’s problem yields

c_ 1 1
= L (33)
c
Both models yiled constant growth just as in the AK model since there are no diminishing returns to
capital. However, the planner’s problem yields greater growth than the decentralized model since in the
planner’s problem, the spillover e¤ects are "internalized," i.e., are taken into account when choosing
the optimal capital stock. The spillover e¤ects are ignored in the decentralized solution.