Nordhaus & Romer (2018): Growth's Greatest Gift and Greatest Threat

Two Externalities That Define Our Future

Economic growth has produced the greatest improvement in human welfare in history. It has also produced the greatest threat to the planet’s climate. The 2018 Nobel Prize honored two economists who brought these two forces — the positive externality of knowledge creation and the negative externality of carbon emissions — into the heart of macroeconomic analysis.

Paul Romer explained where growth comes from: ideas. Unlike physical resources, ideas can be shared without being used up. One person’s use of the Pythagorean theorem doesn’t prevent anyone else from using it. This non-rivalry of knowledge is the engine of sustained growth — and it means the economics of ideas is fundamentally different from the economics of things.

William Nordhaus explained where growth goes wrong: climate change. Burning fossil fuels drives economic activity but warms the planet. Nordhaus built the first quantitative model linking the economy to the climate, providing the tools to calculate the true cost of carbon emissions and design policies to address them.

Romer: Endogenous Growth Theory

Before Romer, growth theory had an embarrassing gap. The Solow model (1987 Nobel) showed that technology drives long-run growth — but treated technology as falling from the sky. Where do new technologies come from? Why do some economies innovate faster than others? The model was silent.

Romer’s breakthrough (1990): technological change is endogenous — it results from deliberate choices by profit-seeking firms and individuals who invest in research and development.

Ideas are fundamentally different from objects:

• Non-rival: A car can only be driven by one person at a time. But a design for a car can be used by every manufacturer simultaneously. Ideas can be shared without being depleted — one person using an idea doesn’t prevent others from using it
• Partially excludable: Through patents and trade secrets, innovators can capture some (but not all) of the returns from their ideas. This creates enough incentive to innovate, even though ideas naturally want to spread
• Increasing returns: Because ideas are non-rival, doubling all inputs (labor, capital, AND knowledge) more than doubles output. This breaks the standard assumption of constant returns to scale and explains why growth can accelerate rather than slow down

The Romer model:

• Firms invest in R&D because they expect to profit from new products or processes
• New ideas build on existing ideas — “standing on the shoulders of giants.” Each innovation makes future innovation easier
• But innovators don’t capture all the benefits of their ideas — knowledge spills over to other firms and future researchers. This positive externality means the market produces too little innovation relative to the social optimum
• The growth rate depends on the number of people engaged in research, the productivity of research, and the incentives to innovate — all of which can be influenced by policy

Policy implications:

• R&D subsidies: Because innovation has positive externalities, the market underinvests. Government subsidies for research can increase the growth rate
• Education: More human capital means more people capable of generating ideas. Investment in education is investment in long-run growth
• Intellectual property: Patents create incentives to innovate by granting temporary monopolies — but too-strong patents can block the knowledge spillovers that fuel further innovation. The optimal patent system balances these forces
• Openness: Trade and migration spread ideas across borders. Closed economies grow slower because they miss out on global knowledge spillovers

Nordhaus: The Economics of Climate Change

In the 1970s, when scientists first warned about greenhouse warming, William Nordhaus began the decades-long project of building an economic model of climate change. The challenge: climate change involves physics, chemistry, ecology, and economics simultaneously, operates over centuries, and requires balancing present costs against uncertain future damages.

The DICE model (Dynamic Integrated model of Climate and the Economy):

• The economy uses fossil fuels to produce output, emitting CO₂ as a byproduct
• CO₂ accumulates in the atmosphere, raising global temperatures according to climate science
• Higher temperatures reduce economic output through damage to agriculture, infrastructure, health, and ecosystems
• The economy can reduce emissions by switching to clean energy or improving efficiency — but this costs money today
• The model finds the optimal balance: how much to spend on reducing emissions now versus accepting damages later

The social cost of carbon:

• Nordhaus’s central contribution was quantifying the social cost of carbon — the economic damage caused by emitting one additional ton of CO₂. His estimates have risen over time: from about $19/ton in early versions to$66/ton in DICE-2023
• This number is policy’s north star: if the social cost of carbon is $66/ton, then any policy that reduces emissions for less than$66/ton is worth doing
• The most efficient tool: a carbon tax set equal to the social cost of carbon. This lets the market find the cheapest ways to reduce emissions, without the government needing to pick winners

Key findings:

• Unchecked climate change could reduce global GDP by several percent per year by the end of this century — with much larger effects in tropical and poor countries
• The optimal policy involves gradually increasing carbon taxes as damages mount — starting at a moderate level and rising over time
• Delay is costly: every decade of inaction makes the eventual adjustment harder and more expensive
• The price of carbon worldwide remains far below the level necessary to meet the Paris Agreement goals — Nordhaus estimates about $80/ton is needed, while the global average is around$3/ton

The Twin Externalities

Romer and Nordhaus, working on seemingly different problems, addressed the same fundamental issue: markets fail when costs or benefits spill over to others.

• Romer’s positive externality: Knowledge creation benefits everyone, but innovators can’t capture all the gains. The market produces too few ideas. Solution: subsidize research, invest in education, protect (but not over-protect) intellectual property
• Nordhaus’s negative externality: Carbon emissions harm everyone, but emitters don’t bear the full cost. The market produces too much pollution. Solution: price carbon through taxes or cap-and-trade systems

Together, they suggest a powerful policy combination: tax the bad (carbon) and subsidize the good (innovation). Green innovation — the intersection of their work — may be the key to solving climate change without sacrificing growth.

Their 2018 Nobel Prize was awarded to Nordhaus “for integrating climate change into long-run macroeconomic analysis” and to Romer “for integrating technological innovations into long-run macroeconomic analysis.”

Explain It to a Child

Imagine a library where every book you read makes you smarter AND makes all other books easier to understand. The more you read, the faster you learn — forever. That’s Romer’s idea about how knowledge works in the economy: ideas build on ideas, and everyone benefits. Now imagine that same library is heated by a giant furnace that burns dirty coal. The library gets warm and cozy, but the smoke drifts into the neighborhood, making people sick. That’s Nordhaus’s idea about climate change: economic activity warms the planet, and the cost falls on everyone — not just the people burning the fuel. Nordhaus figured out how to calculate exactly how much damage each puff of smoke causes, so we can decide how much to spend on cleaning it up. Together, their message is: keep reading (innovating), but fix the furnace (clean energy).