AMBO UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

A TERM PAPER ON

AN OVERVIEW OF ENDOGENEOUS GROWTH

MODELS: THEORY AND CRITIQUE

BY ASHEBIR UFGAHA

SUBMITTED TO :

AMBO UNIVERSIY, WINGET CAMPUS

JANUARY, 20202

ADDIS ABABA, ETHIOPIA

1. INRODUCTION

By definition and convention, an economy can be said to be experiencing economic growth when

there is a sustained annual increase in the real national income over a period of time (Ahuja,

2012). That is, economic growth means a rising trend of net national product. This definition has

been critiqued by economist as unsatisfactory and inadequate in the sense that it does not take

into consideration rising populations within economies as well as macroeconomic variability

(example: inflation). They argued that the possibility exist where incomes may be increasing but

the standard of people may be falling. Therefore, a more common alternative tothe definition of

economic growth (by how it is measured), involves the use of rates of growth in income per

capita – taking into consideration the ability of an economy to expand its output faster than its

growing population – and the levels and growth rates of real per capita Gross National Income

(GNI) – taking into consideration how much of goods and services are available for consumption

and investment to the average citizen – to measure overall economic well-being of citizens.

The recent literature highlights the existence of a variety of channels through which steady-state

growth may emerge endogenously. The new growth theory stressed the importance of

innovation, human capital accumulation, the development of new technologies and financial

intermediation as important determinants of economic growth. The development experience of

East Asian countries also provided several lessons on the impact of policies on economic growth.

It is agreed that government intervention aimed at removing obstacles to market mechanisms or

other sources of market failures is not harmful to growth (Agenor and Montiel, 1996).

According to Salvadori (2003), there are two folds of aim of endogenous growth theory. The first
one is to overcome the shortcomings of the neoclassical growth theory which does not explain

Sustained growth. Secondly, to provide a rigorous model in which all variables crucial for

growth such as savings, investment and technology are the outcome of rational decisions. The

accumulation of factors can be facilitated either by removing the scarcity of natural resources or

by introducing technical progress. As far as the former is concerned, for example, labor has been

straight forwardly transformed into a fully reproducible resource, human capital. As for technical

progress, one of the main features of the endogenous growth theory is the capacity to indigenize

the investment decision yielding technological progress which consists mainly in the introduction

of new intermediate and/or final goods. From this perspective, tourism industry has great

potential in providing market for final goods international tourists need.

According to Heijdra and Ploeg (2006), Research and Development (R&D) activities provide

some new and cheap type of technique of production which is exclusive for the inventor. In this

case, even in the absence of physical and human capital, there can be growth. The model

considers three types of productive sectors each with its own technology and pricing decision.

These are final goods sector, Intermediate goods sector and Research and Development sector

In making a case for the necessity of understanding economic growth for any economy; the most

compelling reason is that economic growth determines the material well-being of the people. It

dictates to a large extent the availability of resources within a society and invariably the choice

patterns of individuals in trying to satisfying their utility preferences. Accelerating economic

growth within an economy has been argued to be the solution of absolute poverty as well as

converging economies (Dreze and Sen, 2002). The relationship between economic growth and

inequality presents another essential reason for understanding growth. Economists have

postulated that growth reduces inequality (Sala – I – Martain, 2006); others have shown that the
relationship changes over time (Kuznets, 1955).

Endogenous growth theory holds that economic growth is primarily the result of endogenous and
not external forces. Endogenous growth theory holds that investment in human capital, innovation,
and knowledge are significant contributors to economic growth. The theory also focuses on
positive externalities and spillover effects of a knowledge-based economy which will lead to
economic development. The endogenous growth theory primarily holds that the long run growth
rate of an economy depends on policy measures. For example, subsidies for research and
development or education increase the growth rate in some endogenous growth models by
increasing the incentive for innovation. Therefore, the aim of this review is against this backdrop.
2. Statement of the Problem
To fully grasp the concept of economic growth, there is a need for a formal theory; for

organizing the facts, clarifying causal interdependencies and relationships, as well as espousing

possible relationships that may exist. In understanding economic growth, as in the general study

of economics, an argument not founded on a clear theoretical framework is seldom informative.

The starting point for conceptualizing economic growth theory and Endogenous Growth Models

(EGM) in particular, is the Neoclassical Growth model (NGM). While the focus of NGM was

primarily on the growth of productive inputs; savings, capital accumulation (associated with

depreciation) in determining economic growth, the EGM builds upon postulates of NGM and

focuses on how innovations and technology can lead to economic growth in the long run.

Given the unavoidable complex nature of modeling, the paper will focus on intuition that the

EGM endeavors to capture. Thus, the paper provides to the reader, a non- technical overview and

critique of the popular endogenous growth model, key literature in the study of the workings of

the model as well as providing important references. The intended audiences are policy makers

and analysts, students and optimistically anyone without a great deal of economic training.

3. Objectives
 The main objective of this term paper is to review that if the capital used for innovative
purposes can be determined and improved without technological progress, with the help of human
capital, economic growth can be achieved.
4. Methods and Materials
4.1. Source of Data
For the purpose of this paper secondary data has been employed from various sources. It is known
that any research analysis depends on the availability and quality of data employed. Thus, this
research depends on secondary data which was collected from various institutions such as
Ministry of Finance and Economic Development (MoFED), Ministry of Culture and Tourism
(MoCT), National Bank of Ethiopia (NBE) and World Bank (WB). Books, journals, research
papers, different encyclopedias and annual reports have been employed.
4.2. Data analysis

5. Review of Related Literature

5.1. The Neoclassical Growth Theory (NGM)

The start point for any study on economic growth is the neoclassical growth model (NGM)(Solow,

1956 and Swan, 1956). The basics of the model are that capital accumulation drives economic

growth in the short run. This can be achieved through economic policy that encourages people to

save more. However,in the long run, the NGM concludes that growth rates will revert to the rate

of technological progress, which NGM takes to be exogenously determined being independent of

economic forces. Thus, the NGM is pessimistic about long run economic growth. It explains this

pessimism using the principle of diminishing marginal productivity, which places a boundary to

how much output a person can produce simply by working with more and more capital.

In less technical terms, consider an economy with a given level of supply of labor and

technology which is assumed to be constant over time. Suppose this labor works with an
aggregate capital stock1K. the maximum amount that can be produced depends on K according to

an aggregate production function. For simplicity, a Cobb Douglas production function is

assumed2. Constant returns to scale – doubling all units will lead to doubling output – are

commonly assumed in this production function. However, due to the assumption of constant

labor supply, decreasing returns will occur when one input increase (in this case capital) and the

other remains constant (Labor). This implies that as more capital is employed, given fixed labor,

its contribution to output declines.

Based on the Cobb Douglas production, the NGM relates the changes in output as input factor

increases. Key to this is capital accumulation 3. In this model, capital is accumulated by saving a

proportion of output in each period and investing it in new capital and a fraction of the capital

stock disappears each year due to depreciation.

Savings,
Depreciation,
1
K here is an aggregate index and it include both human and physical capital.
2
The productOiountpfuuntction will be of the form: Y =F (K, with Fˈ (K) > 0and Fˈ ˈ (K) < 0
3
Capital is accumulated through net investment, I: where I= sY – δK. Where s is the fraction of output saved and δ
is the fraction of output that depreciates.
 Depreciation = δK

Output = F (K)

Savings = sF(K)

0 Capita stock
K0 K*

Figure 2.1
Short run growth as determined in neoclassical growth model

In this model it is capital accumulation through saving a fraction of total output in each period

that brings about increases in output and ultimately economic growth. From figure 2.1, the shape

of the output curve depicts diminishing returns – output increases at an increasing rate, gets to a

maximum and reduces – while the savings curve is a fraction of output. The straight line captures

the amount of savings that will be just enough to keep up with capital depreciation. Given the

production functionY = F (K), where Y is output and depends on the level of capital, K, increases

in K will lead to increases in Y but not by as much as the increase in K. Assume initial capital is

K0, at this point, savings exceeds depreciation and there is enough savings to buy new capital,

induce investment and increase output. This process continues until savings can no longer match

depreciation and capital remains at K* in the long run thereby halting any further increase in

output and economic growth.

The implication of the NGM is that savings (capital accumulation) can account for growths in

output in the short run. However, long run growth rates cannot be explained by the model.

Further increases in the savings rate will only increase the steady state level of capital stock and

not change output levels. To stimulate increases in output, the output curve will expand outwards

over time; signifying that capital becomes more productive at each time period thereby

countering the growth – destroying tendency of diminishing returns. For capital to become more

productive in each time period, there has to be some form of technological progress that is capital

leaning. Thus, the inevitability of the NGM to predict long run growth rates heralded the

endogenous growth models that emphasized technological progress in predicting long run growth

rates.

5.2. Relevant Literature on Neoclassical Growth Models (NGM)

The pioneering articles on neoclassical growth models were by Solow (1956) and Swan(1956)

where exogenous saving rates where the main focus. Endogenous saving rates where later

developed by Cass (1965) and Koopmans (1965). Based on the neoclassical framework, other

studies were later on developed: Sidrauski (1967) included money and inflation in the

neoclassical framework; Brock and Mirman (1972) analyses the neoclassical model with

uncertainty; Barro (1990) studied the implication of government spending in the model; Mankiw,

Romer and Weil (1992) used human capital to illustrate convergence in the neoclassical theory;

Caselli and Ventura (2000) allow for household heterogeneity; Jones and Manuelli (2005)

provide a very simplistic version of the neoclassical model.

5.3. Overview of Endogenous Growth Model (EGM)

Endogenous growth models describe a collection of theories that model economic growth

through the medium of technological discoveries and progress. As seen in the neoclassical

growth model, economic growth is determined by the rates of savings and capital accumulation.

Technological discoveries have no part to play in this growth process and thus taken as

exogenous – determined outside the model- and given. However, according to Aghion and

Howitt (1998) there are ample reasons to believe that technological progress can depend on

economic decisions of economic agents. In the EGM, technology progress is seen as the core

determinant of long run economic growths which the NGM could not account for. Hence,

technological progress becomes endogenous in endogenous growth models.

Recall, that it is the effect of diminishing returns in the neoclassical growth model that limits the

expansion of output and economic growth. To overcome this restriction to economic growth,

EGM inculcates increasing returns to scale. The classical Cobb Douglas production function

exhibits constant returns to scale to the factor inputs. This leaves no reward or incentive for

economic agents to engage in activities that encourage technological progress. Thus any theory

that endogenizes technological progress cannot be based on competitive equilibrium where

factors are rewarded according to their marginal products.

For simplicity and better understanding, this paper will elaborate on 3 (three) of the most

common endogenous growth models:

a) The AK model

b) Product Variety Model

c) The Schumpeterian Growth Model

 5.3.1. The AK Model

The models of endogenous growth are primarily concerned with establishing how technological progress

can bring about increasing returns to scale. The AK model by Arrow (1962) emphasizes the

possibility of productivity depending on output per worker. This implies that technological

progress can occur, though unintended, by “learning by doing”. As workers continue to

specialize in the production process, the productivity of their input will become higher through

this specialization. Technological progress in the AK model is modeled as the difference in the

initial productivity of the factor before learning by doing and the productivity of the factor after

learning by doing – which will be higher.

The AK model is very similar in its postulates of what drives economic growth with the neoclassical

growth model. In the AK neoclassical growth model, economic growth is induced by savings and

capital accumulation, whereas in the AK model, economic growth is induced by savings, capital

accumulation, and efficiency. Efficiency is defined as the increase in the productivity of factor

inputs by “learning by doing”.

5.3.2. PRODUCT VARIETY MODEL

The inability of the AK model to prescribe an adequate description of long run economic growth

motivated other endogenous growth models that emphasized innovation- horizontal innovations.

These innovation based endogenous growth models consist of two parallel branches of which the

product variety is one, and the other, the Schumpeterian growth model. The product variety

model postulates that economic growth is a consequence of the expansion of specialized

intermediate variety of products. As already noted, modeling increasing returns to scale, in a

clear and concise manner, explains long run economic growth. The product variety model does
this by insisting that growth is driven b innovations that lead to the introduction of new varieties. As

summarized:

“Productivity growth is driven both by increased specialization of labor

that works with an increasing number of intermediate inputs and by the

research spillovers, whereby each new innovator benefits from the whole

existing stock of innovations. Ideas are non – trivial, which means they

can be freely used by new innovators in their own research activities. And

they are excludable in the sense that each new innovation is rewarded by

monopoly rents. It is the prospects of these rents that motivate research

activities aimed at discovering new varieties”.

Aghion and Howitt (1992)

The basic product variety model can be characterized into the interactions of 3 (three) sectors –

the research sector – produces research outputs, intermediate goods sector – buys research output

from research sector and produces intermediate goods (inputs for final sector) and the final goods

sector – combines labor and intermediate goods to produce the final good (Mare, 2004). It is the

interaction of the roles of these three sectors that mitigate the problem of diminishing reruns in

modeling long run economic growth.

In the research sector, spillovers are intuitively assumed. These spillovers occur because

innovations in the research sector are non – rival and partially excludable. What this means is

that, once innovations (blueprints, product designs, etc) come out, other researchers can see it

and can develop additional innovations. Also, the researchers have the opportunity of getting

some rewards from these innovations through patents and property rights which they can sell off

to the intermediate sector. This creates an imperfect market for these innovations and the
opportunity of rewards for innovation.

When intermediate sector buys these patents and property rights, they create a form of monopoly

power in that they hold the exclusive right to the use of the innovation. Increasing returns to

scale occurs in the intermediate sector if there is an increase in patents (intermediate goods) and

more intermediate firms (varieties of intermediate goods) enter the sector with the same marginal

productivity (Mare, 2004). Hence more patents leads to more intermediate products and because

of the non – rival nature of innovations and spillovers, will lead to an increase in the variety of

intermediate goods. This limits the effects of diminishing returns in explaining economic growth.

In the final good sector, the intermediate goods and labor are combined to produce the final good

for consumption.

The implications of the product variety model depend on the assumptions that are inherent.

These assumptions are; Spillovers in research and innovation powerful enough to limit

diminishing returns and monopoly power in the intermediate sector with respect to the use of

innovations in the research sector. The model as a whole postulates that economic growth

increases with the productivity of research, as well as with labor supply4.

5.3.3. Relevant Literature on Product Variety Model

Romer (1987) provided a growth model with expanding product varieties with lon run growth

being stable by using expanding sets of input to mitigate diminishing returns. Romer (1990)

modeled the product variety, including a R&D sector that generates designs for new inputs

through horizontal innovations. Grossmanand Helpman (1991a) presents the product variety

4
The idea that economic growth increase with labor supply implies that larger countries should grow faster. This
however is disputed by Jones (1999) who concluded that growth rate have remained relatively stable despite a
substantial increase in the number of researchers in the United States.
 framework with an expansion of consumer products that enter the utility function. Grossman and

Helpman (1991b) have used the product variety model to analyze the effect of market integration

on economic growth. Acemoglu and Zilibotti (2001) integrated directed technological change into

the frame work of expanding varieties to explain productivity differences across countries.

5.4. The Schumpeterian Growth Model

This model of economic growth emphasizes that growth is generated by a sequence of quality

improving or vertical innovations. It is called Schumpeterian because it embodies the forces that

Schumpeter (1942) describes as “creative destruction” – innovation that drive growth creates

new technology and at the same time destroys older technology by making them redundant. This

model is similar to the product variety model in emphasizing innovations and research spillovers

as drivers of economic growth. However, while the product variety concludes that it is the sum

total of expanding varieties of intermediate goods that induces economic growth in the long run,

the Schumpeterian growth model insists that it is the possible improvements (creating better

intermediate goods) in the intermediate sector that explains long run economic growth.

The mechanism of the Schumpeterian growth model is similar to that of the product variety.

However, in the Schumpeterian model, growth results from the rise in the productivity of the

intermediate input by increasing the quality of the intermediate good. The researcher can

successfully innovate – creating a new version of the intermediate goods which is more

productive – or can be unsuccessful, making innovation uncertain and probabilistic. This

uncertainty increases as technology advances because it becomes harder to improve upon

technologically advanced intermediate products. Given the uncertainty and difficulty in

innovating, the researcher is rewarded a monopoly profit which is compared to the cost of
embarking on the research in order to maximize research profits. Thus, uncertainty and

maximizing monopoly research profits determine the frequency of innovations – how long it

takes for innovation to occur – as well as the size of innovations – the productivity effects of

innovations ; two concepts that are paramount in explaining long run economic growth in a

Schumpeterian frame work.

In the Schumpeterian Growth model, diminishing returns is mitigated by creative destruction.

Better intermediate goods are provided for the final sector for the production of consumer goods.

This form of innovation through creative destruction has the following implication on the model:

1) Economic growth increases with the productivity of innovations. This gives importance

to health and education as growth enhancing variables.

2) Economic growth increases with the size of innovations. This emphasizes the need for

countries lagging behind the world technological frontier, to successfully create policy

that helps implement this technology and get rewarded with larger productivity

enhancements.

3) Stronger property rights induce economic growth. This limits the imitation of innovation

in the intermediate sector, thereby encouraging more research as it protects profits

accruing to successful researchers.

4) Scale effects exist. Increased population will induce economic growth. The intuition is

that, there will be an increase in the market size for successful entrepreneurs and an

increase in the pool of researchers.

 5.4.1. Relevant Literature on Schumpeterian Growth Models

Segerstrom et al (1990) provided the seminal approach to modeling vertical innovation. They modeled

growth with product improvements in a fixed number of sectors without uncertainty in

innovation. Aghion and Howitt (1988) and Reinganum (1989) modeled vertical innovation using

techniques from industrial organization theory. Kortum (1997) and Segerstrom (1998)

developed semi – endogenous models to determine the scale effect on economic

growth.Dinopoulos and Syropoulos (2006) also about the efforts to build barriers to entry are

what remove scale effects in a Schumpeterian framework. Laincz and Peretto (2004), Ha and

Howitt (2006) and Ulku (2005) concluded that a Schumpeterian model without scale effects are

more consistent with long run trends in R&D and TFP (total factor productivity) than semi –

endogenous growth models.

6. Critique of Endogenous Growth Models

In the paper, three endogenous growth models – AK model, Product Variety Model and the

Schumpeterian Growth Model – were overviewed in a very simplistic manner for even the

layman. However, this overview will not be complete without highlighting the drawbacks of

these models, according to the literature. In a general sense, Endogenous growth models as a

whole depend to a large extent on assumptions of the neoclassical theory which has proven

inadequate for developing economies. The endogenous growth models abstract from reality

wrongly by assuming the symmetry of sectors in the economy or that there is a single product

market. Inefficiencies arising from poor infrastructure, institutional inadequacies and perfect

markets, institution and transaction costs are some common variables that impede economic

growth in developing economies. It also neglects the political nature of innovation – where

countries create a strong barrier to innovations.

In specific terms, starting with the AK model, the model did not explicitly differentiate between capital

accumulation and technological progress. It lumps up all the characteristics of capital together

with all the characteristics of technological progress. Also, the neoclassical proponents have

argued that the AK model cannot explain cross country convergence – when a country grows

faster if it is farther below its steady state.

For the product variety model, it fails to capture the role of exit and turnover (creative destruction) in the

growth process. Even though there is strong evidence of exit and turnover of firms in inducing

productivity growth (Comin and Mulani, 2007). The Schumpeterian model on the other hand is

plagued with the problems of scale effects – concluding that larger economies can induce

economic growth – and the absence of capital’s role in the growth process. The model also

neglects the problem of financial constraints by assuming perfect financial markets: in reality

some financial markets work better than others.

7. Conclusions

The impact of endogenous growth models can be deduced from its conclusions on the roles and

dynamics of innovations and discovery, introduction of new approaches to modeling economic

growth, and a different perspective from the neoclassical growth theory.Endogenous growth

models are an important theoretical framework for understanding the growth process. They

highlight inter – relationships within the society that helps policy makers. These theories are

important because they emphasize that capital accumulation and innovations can induce

economic growth, while diminishing returns can reduce it. These models show how long run

economic growth can be achieved through spillovers and scale effects of ideas and research

within the economy.

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