Endogenous Growth Theory/

models
Lecture Content
 Introduction:

 A two-sector model with R&D

 The model without capital
 The General Case: The model with
capital
1  Models with human capital
 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.
• It assume that the key determinants of economic
growth are population growth and the accumulation of
human capital and knowledge.
• The main objective is to make the technological
progress an endogenous variable to be explained within
the model, hence the name endogenous growth theory.

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 This model is the simplest possible and basic endogenous
growth model and other endogenous growth models can
be thought as extensions.
 The production function is assumed to be linear in the
only input capital
 Yt = f(k) = AK; …………………………………… (17)
where A = an exogenous constant which reflects the level of technology
K = the aggregate capital
 The key difference with the Solow-Swan model is that here the
inexistence of diminishing return to capital
 Assume a certain fraction of income is saved & invested which
remain constant (s)
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 Two-sector model with R&D
Framework and Assumptions
An additional sector that only does R&D.
Models the production of new technologies –
technological progress is endogenous
The allocation of resources between the conventional
goods-producing sector and the sector producing
R&D is exogenous.
The economy produces two things: consumption
goods and ideas.

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 There are two sectors, a goods-producing sector where
output is produced and an R&D sector where additions
to the stock of knowledge are made. The model assumes
that the economy’s labor force and capital stock are
divided between one goods-producing sector and one
sector conducting R&D:
• Fraction of labor and capital in R&D sector =
• Fraction of labor and capital in goods-producing
sector =
•The production function in the goods-producing sector
takes the form (CRS; homogenous of degree 1:
doubling inputs doubles output).

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 Technological advances depend on the amount of labor
and capital devoted to R&D and the current level of
technology:

This function allows for decreasing, constant or

increasing returns to scale. The value of θ can be both
positive and negative as it reflects the effect of existing
knowledge stock on the success of R&D.
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 For Simplicity depreciation is set to zero then:

The labor force is assumed to grow at rate ‘n’

Still, the model has two stock variables that are

endogenously determined: K & A, Hence it is
more complicated to analyze than the Solow
model
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 The model without capital.

Where there is no capital, the production function for the

goods sector becomes:

Output is proportional to A – hence the dynamics of A

is of particular interest.

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 Taking logs of both sides and differentiate with respect
to time gives us the growth rate of the growth rate of A
(the growth in technological progress):

The initial values of A and L determines the initial

value of gA , which determines the value gA(t) but all
depends on θ.
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 Case 1: θ<1
When θ<1, g·A is positive for small values of gA and
negative for large values this can be shown on the
figure below.

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 There is a unique value of the growth rate of A,gA*
where g A = 0 :i.e., the steady state is where”

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 • The long-run growth rate of output per worker, gA*,
is an increasing function of the population growth.
• An increase in the fraction of the labor force devoted
to R&D, and when θ<1, has a level effect (influences
gA, Eqn 7) but no growth effect on the long run path
of A [ie aL is not found in [eqn 10] but on Eqn 7].
 This is a model of endogenous growth Output growth
occurs because of technological growth.

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 Technology grows because new ideas are created and old
ideas don’t depreciate.
 Technological growth does not depend on the proportion
of people working in research and development
 So, an increase in the share of the population working in
R&D can produce a level effect on technology and
output, But, no growth effect.
 For example, the R&D in a war effort might boost your
output permanently, but would only produce a transitory

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effect on its growth rate.
 Case 2: θ˃1
When θ >1, gA is positive for all values of gA, implying
that the economy is characterized by ever-increasing
growth rather than convergence. The impact of an
increase in the share of the labor force employed in the
R&D sector is substantial through its impact on gA
which in turn affect gA as shown in the diagram below.

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 In this case, there is no steady-state growth rate of

.
technology; the growth rate accelerates
Growth rates of developed countries have been inching
up over the decades. This is one type of fully endogenous
model of growth.
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 Case 3: θ=1
When θ=1, the model
simplifies to:

Growth of ideas depends on population. i.e. it depends on

the proportion of the population working in research and
development.

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  Growth of ideas is accelerating when population
growth is positive, and has no steady state.
 Growth of ideas stops when population growth stops

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When θ=1 existing knowledge is just productive enough in
generating new knowledge that the production of new
knowledge is proportional to the stock. The rate of
knowledge growth is a linear function of the population
growth and the knowledge growth is a linear function of
the labor force and the fraction of it devoted to research
and development.

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 II. The model with capital
The dynamics of knowledge (A) and capital (K)
A: Capital

Now there two endogenous stock variables, A &K in the

model. Substituting the production function [Eqn 1] into
the expression for capital growth [Eqn 3] yields:

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Taking logs of both sides and differentiate with respect to
time results in an expression giving the growth rate of the
growth rate of capital:

The growth rate of capital, gK , is always positive and is

increasing if gA(t)+n-gK(t) > 0 , decreasing if gA(t)+n-
gK(t) < 0 and is zero if gK(t) = n+gA(t).
 The dynamics of the growth rate of capital

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 The growth rate of knowledge is expressed by:

This implies that the growth rate of the knowledge

accumulation is:

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 Implying that the growth rate of capital when knowledge
grows at a constant rate is:

Increasing both K and A by a factor of X increases by a

A factor of X β+θ The key determinants of the
economy’s behavior is now not how θ compares with 1
but how β+θ compares with 1.

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Case 1: θ+β<1.
If θ+β<1, (1-θ)/β is greater than 1 -the locus of points
where gA=0 [the previous figure] is steeper than the locus
where gK=0. The behavior of the growth rates of
knowledge and capital when β+θ<1 implies that regardless
of the initial level, these growth rates converge to E in the
diagram next - a level where they both remain constant:
In this equilibrium g*A and g*K are 0/ satisfy the
equations
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The dynamics of the growth rates of knowledge and capital when
θ+β=1 (n is positive):

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 Case 2: β+θ˃1

Once this occurs the growth rate of both A and K and

hence output growth rate increases continuously. This case
is analogous to the case when θ exceeds 1 in the simple
model with no capital. This can be represented in the
following graph.

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 Case 3: β+θ=1
In this case (1-θ)/β equals 1 and hence the loci gA and gK
have the same slope. In n is positive the gK. =0 line lies
above gA =0 line and the dynamics of the economy is
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similar to those when (θ+β) >1.
 Models with human capital
Output is given by:

[19]
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Where H is the stock of human capital. L continues to
denote the number of workers; thus a skilled worker
supplies both 1 unit of L and some amount of H. We make
our usual assumptions about the dynamics of K and L:

[20]
[21]
The model follows the Solow model and assumes constant
and exogenous technological progress:

[22]
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Finally, for simplicity, human capital accumulation is
modeled in the same way as physical capital accumulation:

[23]
The Cobb-Douglas function can be replaced by a general
production function Y = F(K H, AL) that exhibits
constant returns to scale and that, in intensive form,
satisfies a two-variable analogue of the Inada conditions.

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 Results of AK Model
1. The model allows for growth in output at a rate
determined by (sA-δ).
2. Higher saving (s), higher level of technology (A) and
lower level of depreciation (δ) have positive effects on
the growth rate of output.
3. The model does not exhibit any convergence, it rather
accepts divergence.
4. There exist no transitional dynamics: the growth rate
jumps instantaneously whenever there is a change in
parameter value.

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Criticism on Endogenous Growth Model
• 1st, it is based on CR to capital & leaves unexplained
• 2nd, it remains dependent on some of the traditional
neoclassical assumption that are inappropriate for
developing countries such as the existence of a single
production function, i.e., all sectors are symmetrical,
• 3rd, economic growth in developing countries most of the
times is impeded by inefficiencies arising from
poor infrastructure, inadequate institutional
structures, imperfect capital and goods market.
• The new growth theory, however, does not consider these
factors, and as a consequence its applicability to cross
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country development comparison is limited