Endogenous growth theory
Encyclopedia
Endogenous growth theory holds that economic growth
is primarily the result of endogenous and not external force. In Endogenous growth theory investment in human capital
, innovation
and knowledge are significant contributors to economic growth. The theory also focus on positive externalities and spillover effects of knowledge based economy which will lead to development of economies. The endogenous growth theory also holds that policy measures can have an impact on the long-run growth rate of an economy. For example, subsidies on research and development
or education
increase the growth rate in some endogenous growth models by increasing the incentive to innovation.
factor determining the long run growth. They favoured a model that replaced the exogenous growth variable (unexplained technical progress) with a model in which the key determinants of growth were determined within the model. The initial research was based on the work of Kenneth Arrow
(1962), Hirofumi Uzawa (1965), and Miguel Sidrauski
(1967). Romer (1986), Lucas (1988), and Rebelo (1991) omitted technological change. Instead, growth in these models was due to indefinite investment in human capital
which had spillover effect
on economy and reduces the diminishing return to capital accumulation
.
The AK model
which is the simplest endogenous model, gives a constant-saving-rate of endogenous growth. It assumes a constant, exogenous saving rate and fixed level of the technology. It shows elimination of diminishing returns leading to endogenous growth. However, the endogenous growth theory is further supported with models in which agents optimally determined the consumption and saving, optimizing the resources allocation to research and development leading to technological progress. Romer (1987, 1990) and significant contributions by Aghion and Howitt (1992) and Grossman and Helpman (1991), incorporated imperfect markets and R&D to the growth model.
where
, is a positive constant that reflects the level of the technology.
capital (broad sense to include human capital)
, output per capita and the average and marginal product are constant at the level 
If we substitute
in equation of transitional Dynamics of Solow-Swan model (Exogenous growth model
) which shows how an economy’s per capita incomes converges toward its own steady-state value and to the per capita incomes of other nations.
Transitional Dynamics equation, where Growth rate on
is given by,
on substituting
, we get ,
We return here to the case of zero technological progress,
, because we want to show that per capita growth can now occur in the long run even without exogenous technological change. The figure 1.1 explains the perpetual growth, with exogenous technical progress. The vertical distance between the two line, 
and n+δ gives the
As,
n+δ, so that
. Since the two line are parallel, 
is constant; in particular, it is independent of 
. In other words,
always grows at steady states rate,
.
Since
,
equals 
at every point of time. In addition, since
,the growth rate of 
equals 
. Hence, the entire per capita variable in the model grows at same rate, given by
However, we can observe that
technology displays a positive long-run per capita growth without any exogenous technological development. The per capita growth depends on behavioural factors of the model as the saving rate and population. It is unlike neoclassical model, which is higher saving, s, promotes higher long run per capita growth 
.
. Households are assumed to maximize utility subject to budget constraints while firms maximize profits. Crucial importance is usually given to the production of new technologies and human capital
. The engine for growth can be as simple as a constant return to scale production function (the AK model) or more complicated set ups with spillover
effects (spillovers are positive externalities, benefits that are attributed to costs from other firms), increasing numbers of goods, increasing qualities, etc.
Often endogenous growth theory assumes constant marginal product of capital at the aggregate level, or at least that the limit of the marginal product of capital does not tend towards zero. This does not imply that larger firms will be more productive than small ones, because at the firm level the marginal product of capital is still diminishing. Therefore, it is possible to construct endogenous growth models with perfect competition. However, in many endogenous growth models the assumption of perfect competition is relaxed, and some degree of monopoly
power is thought to exist. Generally monopoly power in these models comes from the holding of patents. These are models with two sectors, producers of final output and an R&D sector. The R&D sector develops ideas that they are granted a monopoly power. R&D firms are assumed to be able to make monopoly profits selling ideas to production firms, but the free entry
condition means that these profits are dissipated on R&D spending.
has written:
in explaining the income divergence between the developing and developed worlds (despite usually being more complex).
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...
is primarily the result of endogenous and not external force. In Endogenous growth theory investment in human capital
Human capital
Human capitalis the stock of competencies, knowledge and personality attributes embodied in the ability to perform labor so as to produce economic value. It is the attributes gained by a worker through education and experience...
, innovation
Innovation
Innovation is the creation of better or more effective products, processes, technologies, or ideas that are accepted by markets, governments, and society...
and knowledge are significant contributors to economic growth. The theory also focus on positive externalities and spillover effects of knowledge based economy which will lead to development of economies. The endogenous growth theory also holds that policy measures can have an impact on the long-run growth rate of an economy. For example, subsidies on research and development
Research and development
The phrase research and development , according to the Organization for Economic Co-operation and Development, refers to "creative work undertaken on a systematic basis in order to increase the stock of knowledge, including knowledge of man, culture and society, and the use of this stock of...
or education
Education
Education in its broadest, general sense is the means through which the aims and habits of a group of people lives on from one generation to the next. Generally, it occurs through any experience that has a formative effect on the way one thinks, feels, or acts...
increase the growth rate in some endogenous growth models by increasing the incentive to innovation.
Models in Endogenous Growth
In the mid-1980s, a group of growth theorist became increasingly dissatisfied with exogenousExogenous
Exogenous refers to an action or object coming from outside a system. It is the opposite of endogenous, something generated from within the system....
factor determining the long run growth. They favoured a model that replaced the exogenous growth variable (unexplained technical progress) with a model in which the key determinants of growth were determined within the model. The initial research was based on the work of Kenneth Arrow
Kenneth Arrow
Kenneth Joseph Arrow is an American economist and joint winner of the Nobel Memorial Prize in Economics with John Hicks in 1972. To date, he is the youngest person to have received this award, at 51....
(1962), Hirofumi Uzawa (1965), and Miguel Sidrauski
Miguel Sidrauski
Miguel Sidrauski was an Argentine economist who made important contributions to the theory of economic growth by developing a dynamic model to describe the effects of money on long-run growth. He also published an article on exchange rate determination...
(1967). Romer (1986), Lucas (1988), and Rebelo (1991) omitted technological change. Instead, growth in these models was due to indefinite investment in human capital
Human capital
Human capitalis the stock of competencies, knowledge and personality attributes embodied in the ability to perform labor so as to produce economic value. It is the attributes gained by a worker through education and experience...
which had spillover effect
Spillover effect
Spillover effects are externalities of economic activity or processes that affect those who are not directly involved. Odours from a rendering plant are negative spillover effects upon its neighbours; the beauty of a homeowner's flower garden is a positive spillover effect upon neighbours.In the...
on economy and reduces the diminishing return to capital accumulation
Capital accumulation
The accumulation of capital refers to the gathering or amassing of objects of value; the increase in wealth through concentration; or the creation of wealth. Capital is money or a financial asset invested for the purpose of making more money...
.
The AK model
AK model
The AK model of economic growth is an endogenous growth model used in the theory of economic growth, a subfield of modern macroeconomics. Around 1980s it became progressively clearer that the standard neoclassical endogenous growth models were theoretically unsatisfactory as a tool to explore long...
which is the simplest endogenous model, gives a constant-saving-rate of endogenous growth. It assumes a constant, exogenous saving rate and fixed level of the technology. It shows elimination of diminishing returns leading to endogenous growth. However, the endogenous growth theory is further supported with models in which agents optimally determined the consumption and saving, optimizing the resources allocation to research and development leading to technological progress. Romer (1987, 1990) and significant contributions by Aghion and Howitt (1992) and Grossman and Helpman (1991), incorporated imperfect markets and R&D to the growth model.
The AK Model
The model works on the property of absence of diminishing returns to capital. The simplest form of production function with diminishing return is: where , is a positive constant that reflects the level of the technology. capital (broad sense to include human capital) , output per capita and the average and marginal product are constant at the level If we substitute
in equation of transitional Dynamics of Solow-Swan model (Exogenous growth modelExogenous growth model
The neoclassical growth model, also known as the Solow–Swan growth model or exogenous growth model, is a class of economic models of long-run economic growth set within the framework of neoclassical economics...
) which shows how an economy’s per capita incomes converges toward its own steady-state value and to the per capita incomes of other nations.
Transitional Dynamics equation, where Growth rate on
is given by,on substituting
, we get ,We return here to the case of zero technological progress,
, because we want to show that per capita growth can now occur in the long run even without exogenous technological change. The figure 1.1 explains the perpetual growth, with exogenous technical progress. The vertical distance between the two line, and n+δ gives theAs,
n+δ, so that. Since the two line are parallel, is constant; in particular, it is independent of . In other words, always grows at steady states rate,.Since
, equals at every point of time. In addition, since,the growth rate of equals . Hence, the entire per capita variable in the model grows at same rate, given byHowever, we can observe that
technology displays a positive long-run per capita growth without any exogenous technological development. The per capita growth depends on behavioural factors of the model as the saving rate and population. It is unlike neoclassical model, which is higher saving, s, promotes higher long run per capita growth .Endogenous versus exogenous growth theory
In neo-classical growth models, the long-run rate of growth is exogenously determined by either the savings rate (the Harrod–Domar model) or the rate of technical progress (Solow model). However, the savings rate and rate of technological progress remain unexplained. Endogenous growth theory tries to overcome this shortcoming by building macroeconomic models out of microeconomic foundationsMicrofoundations
In economics, the term microfoundations refers to the microeconomic analysis of the behavior of individual agents such as households or firms that underpins a macroeconomic theory....
. Households are assumed to maximize utility subject to budget constraints while firms maximize profits. Crucial importance is usually given to the production of new technologies and human capital
Human capital
Human capitalis the stock of competencies, knowledge and personality attributes embodied in the ability to perform labor so as to produce economic value. It is the attributes gained by a worker through education and experience...
. The engine for growth can be as simple as a constant return to scale production function (the AK model) or more complicated set ups with spillover
Knowledge spillover
Knowledge spillover is an exchange of ideas among individuals. In knowledge management economics, a knowledge spillover is a non-rival knowledge market externality that has a spillover effect of stimulating technological improvements in a neighbor through one's own innovation...
effects (spillovers are positive externalities, benefits that are attributed to costs from other firms), increasing numbers of goods, increasing qualities, etc.
Often endogenous growth theory assumes constant marginal product of capital at the aggregate level, or at least that the limit of the marginal product of capital does not tend towards zero. This does not imply that larger firms will be more productive than small ones, because at the firm level the marginal product of capital is still diminishing. Therefore, it is possible to construct endogenous growth models with perfect competition. However, in many endogenous growth models the assumption of perfect competition is relaxed, and some degree of monopoly
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...
power is thought to exist. Generally monopoly power in these models comes from the holding of patents. These are models with two sectors, producers of final output and an R&D sector. The R&D sector develops ideas that they are granted a monopoly power. R&D firms are assumed to be able to make monopoly profits selling ideas to production firms, but the free entry
Free entry
Free entry is a term used by economists to describe a condition in which firms can freely enter the market for an economic good by establishing production and beginning to sell the product....
condition means that these profits are dissipated on R&D spending.
Implications
An Endogenous growth theory implication is that policies which embrace openness, competition, change and innovation will promote growth. Conversely, policies which have the effect of restricting or slowing change by protecting or favouring particular industries or firms are likely over time to slow growth to the disadvantage of the community. Peter HowittPeter Howitt (economist)
Peter Wilkinson Howitt is a Canadian economist. He is the Lyn Crost Professor of Social Sciences at Brown University. Howitt is a Fellow of the Econometric Society since 1994 and a Fellow of Royal Society of Canada since 1992...
has written:
Sustained economic growth is everywhere and always a process of continual transformation. The sort of economic progress that has been enjoyed by the richest nations since the Industrial Revolution would not have been possible if people had not undergone wrenching changes. Economies that cease to transform themselves are destined to fall off the path of economic growth. The countries that most deserve the title of “developing” are not the poorest countries of the world, but the richest. [They] need to engage in the never-ending process of economic development if they are to enjoy continued prosperity. (Conclusion, "Growth and development: a Schumpeterian perspective", 2006 http://www.cdhowe.org/pdf/commentary_246.pdf).
Criticisms
One of the main failings of endogenous growth theories is the collective failure to explain conditional convergence reported in the empirical literature. Another frequent critique concerns the cornerstone assumption of diminishing returns to capital. Some contend that new growth theory has proven no more successful than exogenous growth theoryExogenous growth model
The neoclassical growth model, also known as the Solow–Swan growth model or exogenous growth model, is a class of economic models of long-run economic growth set within the framework of neoclassical economics...
in explaining the income divergence between the developing and developed worlds (despite usually being more complex).
See also
- Economic growthEconomic growthIn economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...
- Human capitalHuman capitalHuman capitalis the stock of competencies, knowledge and personality attributes embodied in the ability to perform labor so as to produce economic value. It is the attributes gained by a worker through education and experience...
- Paul RomerPaul RomerPaul Michael Romer is an American economist, entrepreneur, and activist. He is currently the Henry Kaufman Visiting Professor at New York University Stern School of Business and will be joining NYU as a full time professor beginning in 2011...
- Exogenous growth modelExogenous growth modelThe neoclassical growth model, also known as the Solow–Swan growth model or exogenous growth model, is a class of economic models of long-run economic growth set within the framework of neoclassical economics...
- Mahalanobis modelMahalanobis modelThe Mahalanobis model is a model of economic development, created by Indian statistician Prasanta Chandra Mahalanobis in 1953. Mahalanobis became essentially the key economist of India's Second Five Year Plan, becoming subject to much of India's most dramatic economic debates.-The...
- Ramsey-Cass-Koopmans model
External links
- Economic Growth by Paul RomerPaul RomerPaul Michael Romer is an American economist, entrepreneur, and activist. He is currently the Henry Kaufman Visiting Professor at New York University Stern School of Business and will be joining NYU as a full time professor beginning in 2011...
. - New Growth Theory, Technology and Learning: A Practitioner's Guide, U.S. Economic Development AdministrationEconomic Development AdministrationThe Economic Development Administration is an agency in the United States Department of Commerce that provides grants to economically distressed communities to generate new employment, help retain existing jobs and stimulate industrial and commercial growth.-History:The EDA was established under...
. - Technological Implications of New Growth Theory for the South, United Nations Development ProgrammeUnited Nations Development ProgrammeThe United Nations Development Programme is the United Nations' global development network. It advocates for change and connects countries to knowledge, experience and resources to help people build a better life. UNDP operates in 177 countries, working with nations on their own solutions to...
. - The AK Model by Economic Growth, 2nd Edition Robert J. Barro and Xavier Sala-i-Martin
- The Origins of Endogenous Growth, Romer.M Paul,The Journal of Economic Perspectives, Vol. 8, No. 1. (Winter, 1994), pp. 3-22.