Growth with Quality-Improving Innovations: An Integrated Framework∗

Technological progress, the mainspring of long-run economic growth, comes from innovations that generate new products, processes and markets. Innovations in turn are the result of deliberate research and development activities that arise in the course of market competition. These Schumpeterian observations constitute the starting point of that branch of endogenous growth theory built on the metaphor of quality improvements, whose origins lie in the partial-equilibrium industrial-organization literature on patent races. Our own entry to that literature was the pre-publication version of chapter 10 of Tirole (1988). We argued in Aghion and Howitt (1998) that by using Schumpeter’s insights to develop a growth model with quality-improving innovations one can provide an integrated framework for understanding not only the macroeconomic structure of growth but also the many microeconomic issues regarding incentives, policies and institutions that interact with growth. Who gains from innovations, who loses and how much all depend on institutions and policies. By focusing on these influences in a model where entrepreneurs introduce new technologies that render previous technologies obsolete we hope to understand why those who would gain from growth prevail in some societies, while in others they are blocked by those who would lose. In this chapter we show that the growth model with quality-improving innovations (also referred to as the “Schumpeterian” growth paradigm) is not only versatile but also simple and empirically useful. We illustrate its versatility by showing how it sheds light on such diverse issues as cross-country convergence, the effects of product-market competition on growth, and the interplay between growth and the process of institutional change. We illustrate its simplicity by building our analysis around an elementary discrete-time model. We illustrate its empirical usefulness by summarizing recent papers and studies that test