A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Gersbach, Hans; Sorger, Gerhard; Amon, Christian Working Paper Hierarchical Growth: Basic and Applied Research Economics Working Paper Series, No. 09/118 Provided in Cooperation with: ETH Zurich, CER-ETH – Center of Economic Research Suggested Citation: Gersbach, Hans; Sorger, Gerhard; Amon, Christian (2009) : Hierarchical Growth: Basic and Applied Research, Economics Working Paper Series, No. 09/118, ETH Zurich, CER-ETH - Center of Economic Research, Zurich, http://dx.doi.org/10.3929/ethz-a-005888472 This Version is available at: http://hdl.handle.net/10419/171561 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. 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Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte. may exercise further usage rights as specified in the indicated licence. www.econstor.eu CER-ETH – Center of Economic Research at ETH Zurich Hierarchical Growth: Basic and Applied Research Hans Gersbach, Gerhard Sorger and Christian Amon Working Paper 09/118 August 2009 Economics Working Paper Series Hierarchical Growth: Basic and Applied Research∗ Hans Gersbach Gerhard Sorger CER-ETH Center of Economic Research Department of Economics at ETH Zurich and CEPR University of Vienna 8032 Zurich, Switzerland 1010 Vienna, Austria [email protected] [email protected] Christian Amon CER-ETH Center of Economic Research at ETH Zurich 8032 Zurich, Switzerland [email protected] This Version: July 2009 Abstract We develop a model that incorporates salient features of growth in modern economies. We combine the expanding-variety growth model through horizontal innovations with a hierarchy of basic and applied research. The former extends the knowledge base, while the latter commercializes it. Two-way spillovers reinforce the productivity of research in each sector. We establish the existence of balanced growth paths. Along such paths the stock of ideas and the stock of commercialized blueprints for intermediate goods grow with the same rate. Basic research is a necessary and sufficient condition for economic growth. We show that there can be two different facets of growth in the economy. First, growth may be entirely shaped by investments in basic research if applied research operates at the knowledge frontier. Second, long-run growth may be shaped by both basic and applied research and growth can be further stimulated by research subsidies. We illustrate different types of growth processes by examples and polar cases when only upward or downward spillovers between basic and applied research are present. Keywords: Basic research, applied research, knowledge base, commercialization, hi- erarchical economic growth JEL Classification: H41, O31, O41 ∗We would like to thank Maik Schneider, Ralph Winkler and seminar participants at ETH Zurich for valu- able comments and suggestions. 1 “It is likely that the bulk of the economic benefits of university research come from inven- tions in the private sector that build upon the scientific and engineering base created by uni- versity research, rather than from commercial inventions generated directly by universities.” [Henderson et al. (1998), p. 126] 1 Introduction The innovation processes in both industrialized and industrializing countries are typically characterized by a hierarchy of basic and applied research. Basic research is mainly publicly funded and extends the knowledge base of an economy by generating novel ideas, theories, and prototypes that are usually of no immediate commercial use. Applied research, on the other hand, is primarily carried out by private firms, which commercialize the output of basic research by transforming it into blueprints for new products. Moreover, basic and applied research reinforce each other throughout the entire process of knowledge base extension and commercialization. For example, applied research benefits from basic research because the latter provides knowledge and methods that support the problem-solving processes at research-active private firms, whereas basic research benefits from applied research as the latter identifies unresolved problems and discovers new challenges for basic research. That is, the innovation process is characterized by two-way spillovers between basic and applied research. This paper develops an endogenous growth model that captures the above hierarchy and in- terdependency of the innovation process. We analyze a closed economy with a final and an intermediate goods sector, a basic and an applied research sector, a continuum of infinitely lived households, and a government. Technological progress is the result of a hierarchical innovation process modelled along the lines sketched above: basic research is financed by the government and extends the knowledge base of the economy, whereas applied research is carried out by private firms that transform basic knowledge into blueprints for new inter- mediate goods. In addition, two-way spillovers between basic and applied research reinforce the productivity in each research sector. In this setup, the government can influence growth and welfare of the economy by choosing the size of the basic research sector and by granting subsidies to researchers. Both of these government activities are financed by taxes on labor income. Our model stands in the tradition of the expanding-variety framework of growth through horizontal innovations initiated by Romer (1990).1 The crucial features of our model are the hierarchy in the innovation process and the two-way spillovers between basic and applied research as described above. While Romer and others effectively assumed an exogenous, 1See Gancia and Zilibotti (2005) for a recent review of the development, extensions, and applications of the expanding-variety framework. 2 non-exhaustible pool of knowledge available that can be exploited by applied researchers to invent blueprints for new intermediate goods, we endogenize this knowledge pool as the output of a basic research sector. In other words, we assume that the productivity of applied research is constrained by the “knowledge frontier” of the economy which, in turn, can only be pushed outwards by basic research. In particular, growth is about to cease in the long-run unless the knowledge base of the economy is permanently expanded by basic research. We establish the existence of balanced growth paths. Along such paths the stock of ideas and the stock of commercialized blueprints for intermediate goods grow with the same rate. Ba- sic research is a necessary and sufficient condition for economic growth. We show that there can be two different facets of growth in the economy. First, growth may be entirely shaped by investments in basic research if applied research operates at the knowledge frontier. Sec- ond, long-run growth may be shaped by both basic and applied research and growth can be further stimulated by research subsidies. We illustrate different types of growth processes by examples and polar cases when only upward or downward spillovers are present. In the former case, a higher share of labor employed in basic research translates into higher growth rates and applied research operates at the knowledge frontier. In the latter case, growth is declining if basic research exceeds a certain threshold and ceases entirely if basic research is increased further as undertaking applied research becomes unprofitable. So far, only few attempts have been made to analyze the impact of publicly-funded basic research in a dynamic setup. Among the first were Shell’s (1966, 1967) contributions, which highlight the necessity of allocating economic resources to the process of invention. Thereby, Shell’s concept of technical knowledge, which he treats as a public good financed solely by means of output taxes, corresponds closely to our notion of basic research. Similarly, Gross- man and Helpman (1991) address the positive impact on growth of basic research financed by means of income taxes vis-a-vis` the negative effect caused by the associated tax distor- tions. In order to evaluate the impact of various research policies, Morales (2004) considers an endogenous growth model of vertical innovation incorporating both basic and applied research performed by both private firms and the government. While these and other contri- butions shed light on the positive impact of publicly-funded basic research on growth, they do neither consider the hierarchy of basic and applied research nor the two-way spillovers between the two types of research in the process of innovation. Our formulation of two-way spillovers between basic and applied research follows