What is the basic of Grossman-Helpman model of economic growth?

Grossman-Helpman model of economic growth

In the Grossman-Helpman model of economic growth occurs though innovation. But the innovation comes about through an expanding variety of consumer goods. This is combined with, and also brought about by an accumulation of knowledge.

The way they model consumer goods is as follows. They adopt the formulation of product diversity under monopolistic competition in a 1977 paper by Avinash Dixit and Joseph Stiglitz. Dixit-Stiglitz had formulated the presence of several types of consumer goods by looking at the behaviour of a typical consumer.

Grossman and Helpman extend this formulation on the supply side and bring in dynamic optimisation and optimisation over time. A monopoly firm in their formulation seeks to maximise the stream of returns over time.

Next, Grossman and Helpman look at the costs of the firms and look at the cost of innovation which is the cost of creating a new good. The present value of the profits cannot be larger than the cost of creating a monopoly because if it did, there will be entry by new firms.

Aghion and Howitt’s theory builds upon Grossman and Helpman’s model and they bring in uncertainty into the picture. They also incorporate uncertainty into the R and D process.

They take a model without capital accumulation and full employment. They consider a simplified economy with one good and one factor of production, labour. So final output is a function.

Some labour is devoted to R and D. Innovations take place over time and is constantly taking place. Firms earn ‘interest’ on the value of innovation which is equal to current income plus expected capital gains.

Their model is slightly different from the Schumpeter’s formulation in that theirs is a simplified model in which uncertainty is brought into the picture.

Both the Grossman-Helpman model as well as the Aghion-Howitt model has the feature of technical progress as quality ladder.

This basically means that the models try to portray the process of creative destruction by positing that when new products are introduced, the firm that introduces the improved method of production, or better-quality product will enjoy extra-normal profit, and may also get a larger market share.

Then the other firms try to imitate the new consumer good or new method of production, or even produce still better consumer goods or methods of production. As they introduce newer blueprints or prototypes, the earlier ones may be rendered obsolete.