increasing

increasing - HAKAN YILMAZKUDAY EC 601 ECONOMIC GROWTH...

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HAKAN YILMAZKUDAY EC 601 ECONOMIC GROWTH LECTURE NOTES WEEK 4 INREASING RETURNS AND GROWTH One has to explain the necessity for increasing returns to scale in order to analyze it. Romer (1986) explains this necessity by using the simplicity of the models constructed by decreasing returns to scale. The simplicity comes from the fact that over time, wage rates and capital-labor ratios across counties are expected to converge. In other words, the initial conditions of the economies have no effect on the long run growth of output and consumption of those economies. Realizing this, Romer (1986) proposes a model that offers an alternative view of long run prospects for growth. In his model, the rate of investment and the rate of return on capital may increase rather than decrease with increases in the capital stock. As a result, the level of per capita output in different countries need not converge. That is to say, growth may be slower in less developed countries and may even fail to take place at all. All of these facts can occur due to only one fact: increasing returns to scale. Moreover, Romer (1986) rules out the exogenous technological change and sets up an equilibrium model of endogenous technological change in which long run growth is driven primarily by accumulation of knowledge by forward looking, profit- maximizing agents. The endogenous technology is injected to the model by assuming that knowledge has its own production function. In other words, knowledge is produced by a production function which has inputs and outputs. This production function exhibits decreasing returns to scale, i.e. if you double the number of inputs
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Increasing Returns and Growth 2 the number of outputs will increase to a level less than its double. In addition, investment in knowledge suggests a natural externality. This externality comes from the fact that produced knowledge cannot be kept secret and it spills over through the other firms in the industry. In contrast to models that exhibit decreasing returns to scale, in Romer’s (1986) model, knowledge grows without bound because of the continuous demand for it. The most important part of using this knowledge production is that knowledge, itself, exhibits increasing returns to scale in the production function of consumption goods. In sum, Romer’s (1986) model depends on three crucial assumptions: Increasing returns in the production of consumption goods. Decreasing returns in the production of knowledge. Externalities All of these assumptions have specified tasks to achieve. The importance of externalities comes into picture in order to achieve a competitive equilibrium. Diminishing returns to scale in the production of knowledge is required to ensure that consumption and utility do not grow too fast. And lastly, increasing returns in the production of consumption goods is the main idea in Romer’s (1986) study.
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increasing - HAKAN YILMAZKUDAY EC 601 ECONOMIC GROWTH...

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