A REVIEW ON ENDOGENOUS GROWTH MODEL

Introduction

Endogenous growth theory is an economic theory which argues that economic growth is
generated from within a system as a direct result of internal processes. More specifically, the
theory notes that the enhancement of a nation's human capital will lead to economic growth by
means of the development of new forms of technology and efficient and effective means of
production.

Endogenous growth theory maintains that economic growth is primarily the result of internal
forces, rather than external ones. It argues that improvements in productivity can be tied directly
to faster innovation and more investments in human capital from governments and private sector
institutions.This view contrasts with neoclassical economics. The endogenous growth theory was
developed as a reaction to omissions and deficiencies in the Solow- Swan neoclassical growth model. It
is a new theory which explains the long-run growth rate of an economy on the basis of endogenous
factors as against exogenous factors of the neoclassical growth theory

Endogenous growth theory emerged in the 1980s as an alternative to the neoclassical growth
theory. It questioned how gaps in wealth between developed and underdeveloped countries could
persist if investment in physical capital like infrastructure is subject to diminishing returns.

Economist Paul Romer put forward the argument that technological change is not just an
exogenous by product of independent scientific developments. He sought to prove that
government policies, including investment in R&D and intellectual property laws, helped foster
endogenous innovation and fuel persistent economic growth.

Romer previously complained that his findings hadn’t been taken seriously enough. However, he
was awarded the 2018 Nobel Prize in Economics for his studies on long-term economic growth
and its relationship with technological innovation. His concepts are also regularly discussed by
politicians when they debate ways to stimulate economies.

The need to endogenize the drivers of economic growth continued with Romer in 1986, when he
developed a fully specied mod-el of long-run economic growth with the savings rate assumed to
be endogenous-ly generated by an intertemporal utility maximization supported by technology.
In his assertion, the economic growth path of the technology-driven endogenous model was led
by the accumulation of intangible knowledge that was measura-ble by what he termed
‘forward-looking, prot-maximising agents’ (Romer 1986, p. 1003). The possibility of having
increasing returns driven by an intangible capital good in Romer’s model allowed for the
possibility of having a fully specialized model (which he claimed to be competitive) where per
capita income grows without bound through a monotone function steadily increasing over time
(Romer 1986, p. 1003). He further claimed that since developed countries are usually custodians
of technological advancement more than poor countries, rich countries will tend to grow faster.
The key deviation from the Ramsey-Koopmans-Cass neoclassical endogenous growth model was
adding the concept of increasing marginal returns to the economic growth path based on an
intangible capital good, knowledge (Romer 1986, p. 1004). By adopting all assumptions in the
Ramsey-Koopmans-Cass model and adding another factor – intangible knowledge – Romer
considers a discrete-time model of economic growth with two periods. (Romer 1986, p. 1014).

Another set of endogenous growth models based on intellectual capital was developed by
Grossman and Helpman (1991) and Aghion and Howitt (1992). These endogenous growth
models focused on quality-improving innovations based on Schumpeter’s (1942) creative-
destruction theory. The Schumpeterian theory postulates that aggregate output is accumulated
through a continuum of improvements in intermediate products. Grossman and Helpman (1991,
p. 43) argue that product quality improvements raise total factor productivity in the
manufacturing of consumer and capital goods over time. Aghion and Howitt (1992, p. 323). on
the other hand, model the role of industrial innovations that improve the quality of products.
Both theories are based on Schumpeter’s (1942) theory of creative destruction, where there are
quality ladders in which each new innovation is built based on the previous one (Grossman and
Helpman 1991, p. 44) or “better products render previous ones obsolete” (Aghion and Howitt
1992, p. 323). In these Schumpeterian models, the long-run growth rate, therefore, depends on
the share of GDP spent on research and development and not necessarily on the share of output
that is saved (Stokey 1995).
Another variant of the endogenous growth model that adds an important factor of production,
human capital, was developed by Lucas (1988). Lucas de nes human capital as developments in
skill level where the productivity of a single worker can be increased by increasing his/her skill
level. Lucas postulates that human capital has two eects: human capital eects on existing
factors of production and the production function; and time allocation that aects human capital
accumulation (Lucas 1988, p. 17). His model framework conforms to the classical triad rst
introduced by JB Say’s praxeological deduction on the importance of labour in the accumulation
of output or income. The Lucas (1988) human capital growth model has two solutions to solve:
an optimal path and an equilibrium path.

Problem of Statement

The Solow- Swan neoclassical growth model explains the long-run growth rate of output based
on two exogenous variables: the rate of population growth and the rate of technological progress
and that is independent of the saving rate.

As the long-run growth rate depended on exogenous factors, the neoclassical theory had few
policy implications. As pointed out by Romer, “In models with exogenous technical change and
exogenous population growth, it never really mattered what the government did.”

The new growth theory does not simply criticise the neoclassical growth theory. Rather, it
extends the latter by introducing endogenous technical progress in growth models. The
endogenous growth models have been developed by Arrow, Romer and Lucas, among other
economists. We briefly study their main features, criticisms and policy implications.

The endogenous growth models emphasize technical progress resulting from the rate of
investment, the size of the capital stock, and the stock of human capital. The new growth theories
are based on the following assumptions:

1. There are many firms in a market.

2. Knowledge or technological advance is a non-rival good

3. There are increasing returns to scale to all factors taken together and constant returns to a
single factor, at least for one.
4. Technological advance comes from things people do. This means that technological advance
is based on the creation of new ideas.

5. Many individuals and firms have market power and earn profits from their discoveries. This
assumption arises from increasing returns to scale in production that leads to imperfect
competition.

Criticisms of Endogenous Growth Theory:

Despite the fact that the new growth theory has been regarded as an improvement over the new
classical growth theory, still it has many critics:

1. According to Scott and Auerbach, the main ideas of the new growth theory can be traced to
Adam Smith and increasing returns to Marx’s analysis.

2. Srinivasan does not find anything new in the new growth theory because increasing returns
and endogeneity of variables have been taken from the neoclassical and Kaldor’s models.

3. Fisher criticises the new growth theory for depending only on the production function and the
steady state.

4. To Olson, the new growth theory lays too much emphasis on the role of human capital and
neglects the role of institutions.

5. In the various models of new growth theory, the difference between physical capital and
human capital is not clear. For instance, in Romer’s model, capital goods are the key to
economic growth. He assumes that human capital accumulates and when it is embodied in
physical capital then it becomes a driving force. But he does not clarify which is the driving
force.

6. By using secondary school enrollment as a proxy for human capital in their model, Mankiw,
Romer and Weil find that physical and human capital accumulation cannot lead to perpetual
economic growth.

Policy Implications of Endogenous Growth Theory:

The endogenous growth theory has important policy implications for both developed and
developing economies:

1. This theory suggests that convergence of growth rates per capita of developing and developed
countries can no longer be expected to occur. The increasing returns to both physical and human
capital imply that the rate of return to investment will not fall in developed countries relative to
developing countries.

In fact, the rate of return to capital in developed countries is likely to be higher than that in
developing countries. Therefore, capital need not flow from the developed to the developing
countries and actually the reverse may happen.

2. Another implication is that the measured contribution of both physical and human capital to
growth may be larger than suggested by the Solow residual model. Investment on education or
research and development of a firm has not only a positive effect on the firm itself but also
spillover effects on other firms and hence on the economy as a whole. This suggests that the
residual attributed to technical change in the Solow growth accounting may be actually much
smaller.

3. One of the important implications is that it is not necessary that economies having increasing
returns to scale must reach a steady state level of income growth, as suggested by the Solow-
Swan model.

When there are large positive externalities from new investment on research and development, it
is not necessary for diminishing returns to start. So the growth rate of income does not slow
down and the economy does not reach steady state. But an increase in the saving rate can lead to
a permanent increase in the growth rate of the economy.

4. This further implies that countries having greater stocks of human capital and investing more
on research and development will enjoy a faster rate of economic growth. This may be one of the
reasons for the slow growth rate of certain developing countries.

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