In 2018, U.S. economist Paul M. Romer was co-recipient, along with William D. Nordhaus, of the Nobel Prize in Economic Science for “integrating technological innovations into long-run macroeconomic analysis.”

Romer developed “endogenous growth theory.” Before his work in the 1980s and early 1990s, the dominant economic model of economic growth was one that MIT economist Robert Solow developed in the 1950s. Even though Solow concluded that technological change was a key driver of economic growth, his own model made technological change exogenous. That is, technological change was not something determined in the model but was an outside factor. Romer made it endogenous.

There are actually two very different phases in Romer’s work on endogenous growth theory. Romer (1986) and Romer (1987) had an AK model. Real output was equal to A times K, where A is a positive constant and K is the amount of physical capital. The model assumes diminishing marginal returns to K, but assumes also that part of a firm’s investment in capital results in the production of new technology or human capital that, because it is non-rival and non-excludable, generates spillovers (positive externalities) for all firms. Because this technology is embodied in physical capital, as the capital stock (K) grows, there are constant returns to a broader measure of capital that includes the new technology. Modeling growth this way allowed Romer to keep the assumption of perfect competition, so beloved by economists.

In Romer (1990), Romer rejected his own earlier model. Instead, he assumed that firms are monopolistically competitive. That is, industries are competitive, but many firms within a given industry have market power. Monopolistically competitive firms develop technology that they can exclude others from using. The technology is non-rival; that is, one firm’s use of the technology doesn’t prevent other firms from using it. Because they can exploit their market power by innovating, they have an incentive to innovate. It made sense, therefore, to think carefully about how to structure such incentives.

Consider new drugs. Economists estimate that the cost of successfully developing and bringing a new drug to market is about $2.6 billion. Once the formula is discovered and tested, another firm could copy the invention of the firm that did all the work. If that second firm were allowed to sell the drug, the first firm would probably not do the work in the first place. One solution is patents. A patent gives the inventor a monopoly for a fixed number of years during which it can charge a monopoly price. This monopoly price, earned over years, gives drug companies a strong incentive to innovate.

Another way for new ideas to emerge, notes Romer, is for governments to subsidize research and development.

The idea that technological change is not just an outside factor but itself is determined within the economic system might seem obvious to those who have read the work of Joseph Schumpeter. Why did Romer get a Nobel Prize for his insights? It was because Romer’s model didn’t “blow up.” Previous economists who had tried mathematically to model growth in a Schumpeterian way had failed to come up with models in which the process of growth was bounded.

To his credit, Romer lays out some of his insights on growth in words and very simple math. In the entry on economic growth in The Concise Encyclopedia of Economics, Romer notes the huge difference in long run well being that would result from raising the economic growth rate by only a few percentage points. The “rule of 72” says that the length of time over which a magnitude doubles can be computed by dividing the growth rate into 72. It actually should be called the rule of 70, but the math with 72 is slightly easier. So, for example, if an economy grows by 2 percent per year, it will take 36 years for its size to double. But if it grows by 4 percent per year, it will double in 18 years.

Romer warns that policy makers should be careful about using endogenous growth theory to justify government intervention in the economy. In a 1998 interview he stated:

A lot of people see endogenous growth theory as a blanket seal of approval for all of their favourite government interventions, many of which are very wrong-headed. For example, much of the discussion about infrastructure is just wrong. Infrastructure is to a very large extent a traditional physical good and should be provided in the same way that we provide other physical goods, with market incentives and strong property rights. A move towards privatization of infrastructure provision is exactly the right way to go. The government should be much less involved in infrastructure provision.[1]

In the same interview, he stated, “Selecting a few firms and giving them money has obvious problems” and that governments “must keep from taxing income at such high rates that it severely distorts incentives.”

In 2000, Romer introduced Aplia, an on-line set of problems and answers that economics professors could assign to their students and easily grade. The upside is that students are more prepared for lectures and exams and can engage with their fellow students in economic experiments on line. The downside of Aplia, according to some economics professors, is that students get less practice actually manually drawing demand and supply curves.

In 2009, Romer started advocating “Charter Cities.” His idea was that many people are stuck in countries with bad rules that make wealth creation difficult. If, he argued, an outside government could start a charter city in a country that had bad rules, people in that country could move there. Of course, this would require the cooperation of the country with the bad rules and getting that cooperation is not an easy task. His primary example of such an experiment working is Hong Kong, which was run by the British government until 1997. In a 2009 speech on charter cities, Romer stated, “Britain, through its actions in Hong Kong, did more to reduce world poverty than all the aid programs that we’ve undertaken in the last century.”[2]

Romer earned a B.S. in mathematics in 1977, an M.A. in economics in 1978, and a Ph.D. in economics in 1983, all from the University of Chicago. He also did graduate work at MIT and Queen’s University. He has taught at the University of Rochester, the University of Chicago, UC Berkeley, and Stanford University, and is currently a professor at New York University.

He was chief economist at the World Bank from 2106 to 2018.

 

[1] “Interview with Paul M. Romer,” in Brian Snowdon and Howard R. Vane, Modern Macroeconomics: Its Origins, Development and Current State, Cheltenham, UK: Edward Elgar, 2005, p. 690.

[2] Paul Romer, “Why the world needs charter cities,” TEDGlobal 2009.


About the Author

 

David R. Henderson is the editor of The Concise Encyclopedia of Economics. He is also an emeritus professor of economics with the Naval Postgraduate School and a research fellow with the Hoover Institution at Stanford University. He earned his Ph.D. in economics at UCLA.


Selected Works

 

  1. “Increasing Returns and Long-Run Growth.” Journal of Political Economy, Vol. 94, No. 5, pp. 1002-1037.
  2. “Growth Based on Increasing Returns Due to Specialization.” American Economic Review, Papers and Proceedings, Vol. 77, No. 2, pp. 56-62.
  3. “Endogenous Technological Change.” Journal of Political Economy. Vol. 98, No. 5, S71-S102.
  4. “Mathiness in the Theory of Economic Growth.” American Economic Review, Vol. 105, No. 5, pp. 89-93.