1. Economics 216: The Macroeconomics of Development Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.) Kwoh-Ting Li Professor of Economic Development Department of Economics Stanford University Stanford, CA 94305-6072, U.S.A. Spring 2000-2001 Email: ljlau@stanford.edu; WebPages: http://www.stanford.edu/~ljlau

2. Lecture 14 Endogenous Economic Growth Lawrence J. Lau, Ph. D., D. Soc. Sc. (hon.) Kwoh-Ting Li Professor of Economic Development Department of Economics Stanford University Stanford, CA 94305-6072, U.S.A. Spring 2000-2001 Email: ljlau@stanford.edu; WebPages: http://www.stanford.edu/~ljlau

3. Lawrence J. Lau, Stanford University3 Endogenous Technical Progress u Technical progress occurs through the expansion of the set of production possibilities (technical progress) so that a greater level of output can be produced with the same inputs u The expansion of the production possibilities set is endogenous rather than exogenous; it is the result of purposive activity (Romer, Grossman and Helpman) u The expansion can be attributed to investment in knowledge capital (or more generally to intangible capital) u Investment is motivated by the possibility of monopoly rents u The induced innovation hypothesis--investment in innovation (e.g., R&D) occurs in the direction that potentially lowers the cost of production the most, given the prevailing and expected relative factor prices u The learning-by-doing hypothesis (Arrow)

4. Lawrence J. Lau, Stanford University4 Increasing Returns and Knowledge Capital u There are increasing returns in the production of knowledge capital at the firm level u Fixed cost of entry u Winner-take-all u There are positive externalities in the production of knowledge capital at the aggregate, macroeconomic level u Non-appropriability and spillover effects u Once knowledge capital has been created, there is potentially a range of increasing returns in its utilization in production because the marginal cost of additional use is zero (Non-rival nature of knowledge capital, subject to excludability--legal (patents, trade secrets, knowhow), financial, and technological (including quality of manpower)) u However, knowledge capital can depreciate, and can become obsolete, due to changes in factor prices, the legal environment and demand conditions

5. Lawrence J. Lau, Stanford University5 The Creation of Knowledge Capital u Large fixed investment and thus increasing returns at least over a range u Uncertain outcome u Winner-take-all and thus market increasing returns to scale u Loser-loses-all u Potential non-appropriability (non-excludability) u Investment can be built upon social knowledge capital (that may be distinct from and in general less than privately usable knowledge capital) u Whether there are increasing returns in the creation of knowledge capital at the aggregate level depends on the extent of the spillover effects compared to the extent of competitive duplication of investment--Is the aggregate probability of innovation enhanced? (It depends on the degree of independence of the directions of R&D efforts)

6. Lawrence J. Lau, Stanford University6 Increasing Returns to Knowledge Capital u Let K and K* be the quantities of physical and knowledge capital respectively, and L be the quantity of labor, then the production function Y = F(K*, K, L) exhibits constant returns to scale in K and L by the replication argument u If K* were non-rival, then the same K* can be used at more than one installation, thus, in the aggregate, if there are n installations each with the same K and L, output is given by Y* = nF(K*, K, L), with n some integer u If the marginal product of F(K*, K, L) with respect to K* is positive, then in the the aggregate, production should exhibit exhibit increasing returns to scale in K*, K and L

7. Lawrence J. Lau, Stanford University7 The Role of Excludability: The Non-Excludable Case u If K* is not excludable, so that it is freely accessible to all, there are a number of consequences: u Since there are problems of non-appropriability and free-ridership in addition to the intrinsic high risk, private investment in knowledge capital will not be undertaken u Public investment will be undertaken to the point that the expected marginal social product of knowledge capital is equal to the social rate of return u Once created, knowledge capital is utilized by private firms until its marginal private product is zero (reflecting its price) u The contribution of knowledge capital is maximized when the number of firms is maximized so that the same K* can be utilized to the greatest extent u Thus, the firms will operate at the minimum efficient scale (if in fact F(K*, K, L) exhibits constant returns to scale in K and L, then the size distribution of the firms can be arbitrary) u Profit will be zero under perfect competition with free entry and exit u The important point to note is that in equilibrium, the marginal product of existing knowledge capital is zero

8. Lawrence J. Lau, Stanford University8 The Role of Excludability: The Excludable Case u If K* is excludable, then a firm with a piece of knowledge capital that other firms do not have will have lower operating costs and thus will be able to establish a monopoly position in the supply of its output (bear in mind that it is the relative quantities of K* between two firms that matter, not the absolute quantities when it comes to profits) and make monopoly profits (this is precisely the motivation for innovation) u Such a firm will potentially face a downward sloping demand curve for its output u Private investment in knowledge capital will be undertaken to the point that the expected marginal private revenue product of knowledge capital is equal to the private rate of return

9. Lawrence J. Lau, Stanford University9 The Role of Excludability: The Excludable Case u If the firm is risk-neutral, then (1-1/  )  F/  K* = r/P, where  is the absolute value of the price elasticity of demand for the output, r is the nominal rate of interest and P is the price of the output u  >1 at the profit-maximizing equilibrium, otherwise no interior profit-maximizing equilibrium exists u It follows that private investment in knowledge capital will fall short of the efficiency condition of marginal productivity being equal to the real private rate of return

10. Lawrence J. Lau, Stanford University10 Increasing Returns to Aggregate Knowledge Capital u In either case, there is no tendency for infinite expansion of K* u Thus, existence of increasing returns to scale to knowledge capital at the firm level does not necessarily imply that there are increasing returns to scale to aggregate knowledge capital in aggregate production in equilibrium u In particular, it does not necessarily imply that the marginal productivity of knowledge capital in aggregate production is increasing in the quantity of aggregate knowledge capital u The existence of monopoly rents implies that the economy does not operate on the production possibility frontier (Price not equal to marginal cost), I.e., production is not efficient u Whether social welfare is increased or decreased and by how much depend on the extent of the monopoly rents and the extent of the spillover effects (externalities)

11. Lawrence J. Lau, Stanford University11 Increasing Returns to Aggregate Knowledge Capital u Monopoly profits depend on relative K* and not on absolute K* u Rising or constant marginal productivity of aggregate knowledge capital in the aggregate production function depends on an economically significant spillover effect, that is, on the lack of full appropriability of the benefits of newly created knowledge capital (e.g., new software on existing computers) u However, even free software does not always have takers (marginal product = 0) u There is no compelling theoretical or empirical reason to assume that physical capital and knowledge capital are always used in fixed proportions--it is assumed solely for the purpose of analytical convenience

12. Lawrence J. Lau, Stanford University12 Increasing Returns at the Microeconomic Level u Technological increasing returns to scale u Market increasing returns to scale

13. Lawrence J. Lau, Stanford University13 Technological Increasing Returns to Scale u High fixed cost u Zero or low marginal cost u Price=marginal cost implies failure to recover fixed cost u Entry barrier u Natural Monopoly

14. Lawrence J. Lau, Stanford University14 Monopolies Based on Technologies u Technological innovations protected by patents, know- how, trade secrets, copyrights, and other forms of intellectual property rights provide the basis for technologically based monopolies u Excludability u The product cycle in the absence of network externalities u Sequential price discrimination u Economies of scale and learning by doing u Commodity phase

15. Lawrence J. Lau, Stanford University15 Market Increasing Returns to Scale u What is new? We may call it market increasing returns to scale (as distinct from technological increasing returns to scale, characterized by the higher the market share, the higher the marginal revenue, i.e. increasing the market share enhances the power to raise prices)

16. Lawrence J. Lau, Stanford University16 Two Sources of Market Increasing Returns to Scale u (1) Network or use externalities u The benefit of a product or service to the user/consumer depends on how many other people are using it-- (externalities in consumption or in use, in the demand curve) u Thus, the demand curves are interdependent--one can derive the dynamic profits of such demand curves to obtain a diffusion profile u Network externalities—the benefits of standardization (compatibility, exchangeability, communicability) u Setting and control of standards=control of market

17. Lawrence J. Lau, Stanford University17 Two Sources of Market Increasing Returns to Scale u (2) User-specific investment u Learning by doing (software, typing keyboard) u Prior use, habit formation (addiction) u Example: English is everyone’s second language. Once in place, it is very difficult to dislodge. (However, the entry cost of teaching English is very low and that is why there is no monopoly profit.)

18. Lawrence J. Lau, Stanford University18 Implications of Market Increasing Returns to Scale u First-move advantage u Winner-take-all nature of competition u Specific market strategies u Low or zero initial price (thus driving out competitors and potential competitors and encouraging addiction), followed by high monopoly price u Planned obsolescence

19. Lawrence J. Lau, Stanford University19 The Tournament Model of Technological Competition u “Winner takes all” u Reinforced by increasing returns to scale u First move advantage u Path dependence--durability of market shares (and hence monopoly profits)! u Example: u Pharmaceutical R&D u VHS versus Beta u Operating system of personal computers u The quality-ladder model of Grossman and Helpman (1991)

20. Lawrence J. Lau, Stanford University20 The Distinction between Social and Private Rates of Return u Competition for monopoly rents u “Winner takes all” results in negative rates of return for losers u Social rate of return can be below private rate of return-- possibility of over-investment u However, monopoly rents provide the incentive for innovative activity

21. Lawrence J. Lau, Stanford University21 Question: Does Endogenous Growth Imply Macroeconomic Increasing Returns to Scale? u Externalities as a source of increasing returns--depends on the extent of the spillover effect relative to the extent of uneconomic duplication and competition u Given increasing returns to knowledge capital, but eventual decreasing returns in the production of knowledge, the aggregate output may not necessarily exhibit increasing returns in conventional inputs and cumulative investment in knowledge-producing capital u Even (or perhaps especially) if knowledge capital is made freely available to all, the value of its marginal product may reach zero in equilibrium

22. Lawrence J. Lau, Stanford University22 The Role of Knowledge Capital u Is knowledge capital super-additive or sub-additive? u Is social knowledge capital greater than or less than the sum of privately usable knowledge capital, taking into account the common initial base of social knowledge capita? u The roles of rivalry, excludability, non-appropriability, spillover, and winner-takes-all

23. Lawrence J. Lau, Stanford University23 Aggregation u What is the effect of purposive innovation-based technical progress at the microeconomic level on measured technical progress at the macroeconomic level?

24. Lawrence J. Lau, Stanford University24 Intertemporal Behavior u Can the steady-state rate of growth be raised (permanently) with appropriate government policy (e.g., good government, good system of law enforcement, stable currency and financial system)? u It is necessary to distinguish between an effect on the level and an effect on the rate of growth and between an effect on the instantaneous rate of growth and the steady-state rate of growth u Are there cycles or waves in innovation?

25. Lawrence J. Lau, Stanford University25 The Evolution of Measured Technical Progress over Time u Can one explain the evolution of measured technical progress over time? u Some problems of the recent measures of total factor productivity u The measurement of labor inputs is based on a standard number of hours, or hours paid, rather than hours worked--the discrepancy between hours paid and hours work for employees in the high-technology sector is believed to have risen during the high-technology boom of the past five years u The change in the accounting practice on expenditure on software not bundled with hardware from full expensing to capitalizing will in the first few years result in a higher measured real GDP even though nothing has changed u The hedonic price index adjustment may over-state the pecuniary benefits of purely technological innovations u The price indexes may not have taken fully into account the shift in the composition of consumption and investment away from goods to services. The prices of services, however, have risen faster than the prices of goods u The pricing of upgrades of subscription type services--how to distinguish between quality improvement and pure price increase