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 that 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).

The simplest models of endogenous technological change are those in which R&D ex­pands the variety of inputs or machines used in production. This chapter focuses 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” preferences, 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 the baseline model of process innovation presented below 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 in the next chapter, I use the Dixit-Stiglitz constant elasticity structure introduced in the previous chapter.

13.1.