As emphasized in the previous chapter, the key to understanding endogenous technolog­ical progress is that R&D is a purposeful activity, undertaken for profits, and the knowledge (machines, blueprints, or new technologies) that it generates increases the productivity of existing factors of production.

The first endogenous technological change models were for­mulated by Romer (1987 and 1990). Different versions have been analyzed by Segerstrom, Anant and Dinopoulos (1990), Grossman and Helpman (1991a,b), Aghion and Howitt (1992).

The simplest models of endogenous technological change are those in which R&D ex­pands the variety of inputs or machines used in production. In this chapter, we focus on models with expanding input varieties; research will lead to the creation of new varieties of inputs (machines) and a greater variety of inputs will increase the “division of labor,” rais­ing the productivity of final good firms. This can therefore be viewed as a form of process innovation. An alternative, formulated and studied by Grossman and Helpman (1991a,b), focuses on product innovation. In this model, research leads to the invention of new goods, and because individuals have love-for-variety, they derive greater utility when they consume a greater variety of products. Consequently “real” income increases as a result of these product innovations. The comparison of Grossman-Helpman’s model of product innovation with our baseline model of process innovation will show that the two models are mathematically very similar (though the model of product innovation is slightly more involved and is thus treated at the end of this chapter).

In all of these models, and also in the models of quality competition we will see below, we will use the Dixit-Stiglitz constant elasticity structure introduced in the previous chapter.

13.1.