The Problem of Economic Development

Models of Imperfect Competition

A main branch of the endogenous growth literature consists of those papers that explicitly model the decisions of private agents to undertake costly research and development. These papers introduce imperfectly competitive elements to the models by conferring monopoly power to the successful innovator. Without the potential to earn monopoly profits, no self-interested agent would incur the costs to engaging in R&D activities. The pioneer papers in this literature are Romer (1990), Grossman and Helpman (1991), and Aghion and Howitt (1992). More recent efforts in this literature, for example Jones (1995), Segerstrom (1998), and Young (1998) are variations on these original papers intended to remove an undesirable prediction of these models, namely that countries with larger populations have higher growth rates and possibly higher levels of per capita output. The prediction known as the scale effect is not borne out by the data.1 Most economists agree that technological change is the source of sustained increases in per capita output. Most economists further agree that the creation of this knowledge is the result of research and development efforts undertaken by individuals and firms. The main reason the United States is so much richer today compared to 200 years ago is because of new inventions and discoveries made over this time. This branch of endogenous growth theory, therefore, has the potential to improve our understanding 1 See Jones (1995) for a discussion of this data.

4 of how knowledge has grown and how the leading industrialized countries have been able to double their incomes approximately every 35 years over the last two centuries. R&D models, however, do not help us understand why the whole world is not rich. Currently, there are huge differences in living standards between countries. The average person living in Myanmar or Burundi is reported to be close to 30 times poorer than the average person living in the United States. Myanmar and Burundi are not outliers in this respect. Figure 1 taken from Parente and Prescott (2000, p. 12) shows the distribution of per capita output relative to the U.S. level across countries in 1988. The countries included in the plot consist of all those with 1973 populations of at least one million and for which observations are available for all years over the 1960-88 period. As can be seen in Figure 1, there are about 25 countries in 1988 with relative incomes less than 6 percent the U.S. level. These cross-country income differences are much larger than the within-country income differences by most measures. For example, in 1988, the factor difference in the permanent income levels of individuals in the 90th and 10th percentiles in the United States was 4. For a similar comparison across countries, this factor difference was 20. It is true that poor countries do not engage in R&D. However, they do not have to. There is a far less costly way for them to increase their per capita output. Poor countries need only adopt readily available technologies developed elsewhere in the world. This is, in fact, how the Japanese and South Koreans went from being relatively poor countries to relatively rich countries in the postwar period. It is also how the Chinese in the last decade have realized large increases in per capita output. The relevant question, then, is

5 why don't all poor countries adopt more productive readily available technologies? R&D models do not provide an answer to this question. B. Models of Perfect Competition Not all endogenous growth theory models R&D as the source of sustained economic growth. A large number of authors have constructed models whereby private agents do not undertake R&D and yet there is sustained growth. These models do not have to deviate from the assumption of perfectly competitive markets. These models tend to focus on the decision of agents to accumulate capital, where capital can be tangible or intangible in nature.2 The key abstraction of these models for generating this result is that there are no diminishing returns to reproducible capital at the aggregate level. The pioneer works in this branch of the endogenous growth literature are Romer (1986), Lucas (1988), and Rebelo (1991). These models have the property that cross-country differences in policy or preferences lead to permanent differences in growth rates of per capita output. Several of these models can be interpreted as models of technology adoption, since technology adoption in one way or another represents the accumulation of intangible capital. Nevertheless, these models are not useful theories of economic development. They are not useful because they fail to account for several key development facts. To establish this point, a brief review of the evolution of the world income distribution is warranted download