Endogenous growth theory

Endogenous growth theory holds that economic growthis primarily the result of endogenous and not externalforces.[1] Endogenous growth theory holds that invest-ment in human capital, innovation, and knowledge aresignicant contributors to economic growth. The the-ory also focuses on positive externalities and spillover ef-fects of a knowledge-based economy which will lead toeconomic development. The endogenous growth theoryprimarily holds that the long run growth rate of an econ-omy depends on policy measures. For example, subsidiesfor research and development or education increase thegrowth rate in some endogenous growth models by in-creasing the incentive for innovation.

1 Models in Endogenous GrowthIn the mid-1980s, a group of growth theorists be-came increasingly dissatised with common accounts ofexogenous factors determining long-run growth. They fa-vored a model that replaced the exogenous growth vari-able (unexplained technical progress) with a model inwhich the key determinants of growth were explicit in themodel. The work of Kenneth Arrow (1962), HirofumiUzawa (1965), and Miguel Sidrauski (1967) formed thebasis for this research.[2] Paul Romer (1986), RobertLucas (1988),[3] and Sergio Rebelo (1991)[4][5] omittedtechnological change instead, growth in these models isdue to indenite investment in human capital which hadspillover eect on economy and reduces the diminishingreturn to capital accumulation.[6]

The AK model, which is the simplest endogenous model,gives a constant-saving-rate of endogenous growth. It as-sumes a constant, exogenous, saving rate. It models tech-nological progress with a single parameter (usually A). Ituses the assumption that the production function does notexhibit diminishing returns to scale to lead to endogenousgrowth. Various rationales for this assumption have beengiven, such as positive spillovers from capital investmentto the economy as a whole or improvements in technol-ogy leading to further improvements (i.e. learning-by-doing). However, the endogenous growth theory is fur-ther supported with models in which agents optimally de-termined the consumption and saving, optimizing the re-sources allocation to research and development leadingto technological progress. Romer (1987, 1990) and sig-nicant contributions by Aghion and Howitt (1992) andGrossman and Helpman (1991), incorporated imperfectmarkets and R&D to the growth model.[6]

2 The AK ModelMain article: AK model

The model works on the property of absence of diminish-ing returns to capital. The simplest form of productionfunction with non-diminishing return is:

Y = AK

where

A

K

Now, assume output per capita be determined by the con-stant A > 0

y = Ak

k = capital per workery = output/income per worker

If we substitute f(k)k = A in equation of transitionalDynamics of Solow-Swan model (Exogenous growthmodel), where f(k) is the output function per worker, itis seen how an economys per capita incomes convergestoward its own steady-state value and to the per capitaincomes of other nations.Transitional Dynamics equation, where Growth rate on kis given by,

K = _k/k = s:f(k)/k (n+ ) ;

on substituting A , we get,

K = sA (n+ ) ;

We return here to the case of zero technological progress,x = 0 , because we want to show that per capita growthcan now occur in the long-run even without exogenoustechnological change. The gure 1.1 explains the per-petual growth, with exogenous technical progress. The

1

2 5 CRITICISMS

vertical distance between the two line, sA and n+ givesthe KAs, sA > n+, so that K > 0 . Since the two line areparallel, K is constant; in particular, it is independentof K . In other words, K always grows at steady statesrate, K = sA (n+ ) ; .Since

y = AK , K equals K

at every point of time. In addition, since

c = (1 s)ythe growth rate of

c equals K .

Hence, the entire per capita variable in the model growsat same rate, given by

= sA (n+ ) ;However, we can observe that y = AK technology dis-plays a positive long-run per capita growth without anyexogenous technological development. The per capitagrowth depends on behavioural factors of the model asthe saving rate and population. It is unlike neoclassicalmodel, which is higher saving, s, promotes higher long-run per capita growth .[6]

3 Endogenous versus exogenousgrowth theory

In neo-classical growth models, the long-run rate ofgrowth is exogenously determined by either the savingsrate (the HarrodDomar model) or the rate of tech-nical progress (Solow model). However, the savingsrate and rate of technological progress remain unex-plained. Endogenous growth theory tries to overcome thisshortcoming by building macroeconomic models out ofmicroeconomic foundations. Households are assumed tomaximize utility subject to budget constraints while rmsmaximize prots. Crucial importance is usually given tothe production of new technologies and human capital.The engine for growth can be as simple as a constant re-turn to scale production function (the AKmodel) or morecomplicated set ups with spillover eects (spillovers arepositive externalities, benets that are attributed to costsfrom other rms), increasing numbers of goods, increas-ing qualities, etc.Often endogenous growth theory assumes constantmarginal product of capital at the aggregate level, or at

least that the limit of the marginal product of capital doesnot tend towards zero. This does not imply that largerrms will be more productive than small ones, becauseat the rm level the marginal product of capital is stilldiminishing. Therefore, it is possible to construct en-dogenous growth models with perfect competition. How-ever, in many endogenous growth models the assumptionof perfect competition is relaxed, and some degree ofmonopoly power is thought to exist. Generally monopolypower in these models comes from the holding of patents.These are models with two sectors, producers of nal out-put and an R&D sector. The R&D sector develops ideasthat they are granted a monopoly power. R&D rms areassumed to be able to makemonopoly prots selling ideasto production rms, but the free entry condition meansthat these prots are dissipated on R&D spending.

4 ImplicationsAn Endogenous growth theory implication is that policieswhich embrace openness, competition, change and inno-vation will promote growth.[7] Conversely, policies whichhave the eect of restricting or slowing change by protect-ing or favouring particular existing industries or rms arelikely over time to slow growth to the disadvantage of thecommunity. Peter Howitt has written:

Sustained economic growth is everywhereand always a process of continual transforma-tion. The sort of economic progress that hasbeen enjoyed by the richest nations since theIndustrial Revolution would not have been pos-sible if people had not undergone wrenchingchanges. Economies that cease to transformthemselves are destined to fall o the path ofeconomic growth. The countries that mostdeserve the title of developing are not thepoorest countries of the world, but the rich-est. [They] need to engage in the never-endingprocess of economic development if they areto enjoy continued prosperity. (Conclusion,Growth and development: a Schumpeterianperspective, 2006 ).

5 CriticismsOne of the main failings of endogenous growth theories isthe collective failure to explain conditional convergencereported in the empirical literature.[8] Another frequentcritique concerns the cornerstone assumption of dimin-ishing returns to capital. Stephen Parente contends thatnew growth theory has proven no more successful thanexogenous growth theory in explaining the income diver-gence between the developing and developed worlds (de-spite usually being more complex).[9] Paul Krugman crit-

3icized endogenous growth theory as nearly impossible toempirically verify; too much of it involved making as-sumptions about how unmeasurable things aected otherunmeasurable things.[10]

6 See also

Economic growth

Human capital

FeldmanMahalanobis model

SolowSwan model, the exogenous growth model

RamseyCassKoopmans model, a microfoundedgrowth model with innite horizon

7 Notes[1] Romer, P. M. (1994). The Origins of Endogenous

Growth. The Journal of Economic Perspectives 8 (1): 322. doi:10.1257/jep.8.1.3. JSTOR 2138148.

[2] Monetary Growth Theory. newschool.edu. 2011. Re-trieved 11 October 2011.

[3] Lucas, R. E. (1988). On the mechanics of Economic De-velopment. Journal of Monetary Economics 22.

[4] Rebelo, Sergio (1991). Long-Run Policy Analysis andLong-Run Growth. Journal of Political Economy 99 (3):500. doi:10.1086/261764.

[5] Carroll, C. (2011). The Rebelo AK Growth Model.econ2.jhu.edu. Retrieved 11 October 2011. the steady-state growth rate in a Rebelo economy is directly propor-tional to the saving rate.

[6] Barro, R. J.; Sala-i-Martin, Xavier (2004). EconomicGrowth (2nd ed.). New York: McGraw-Hill. ISBN 0-262-02553-1.

[7] Fadare, Samuel O. Recent Banking Sector Reforms andEconomic Growth in Nigeria. Middle Eastern Financeand Economics (8 (2010)).

[8] See Sachs, Jerey D.; Warner, Andrew M. (1997). Fun-damental Sources of Long-Run Growth. American Eco-nomic Review 87 (2): 184188. JSTOR 2950910.

[9] Parente, Stephen (2001). The Failure of EndogenousGrowth. Knowledge, Technology & Policy 13 (4): 4958. doi:10.1007/BF02693989.

[10] Krugman, Paul (August 18, 2013). The New GrowthFizzle. New York Times.

8 Further reading Acemoglu, Daron (2009). Endogenous Techno-logical Change. Introduction to Modern EconomicGrowth. Princeton University Press. pp. 411533.ISBN 978-0-691-13292-1.

Barro, Robert J.; Sala-i-Martin, Xavier (2004).One-Sector Models of Endogenous Growth. Eco-nomic Growth (Second ed.). New York: McGraw-Hill. pp. 205237. ISBN 0-262-02553-1.

Farmer, Roger E. A. (1999). Endogenous GrowthTheory. Macroeconomics (Second ed.). Cincin-nati: South-Western. pp. 357380. ISBN 0-324-12058-3.

Romer, David (2011). Endogenous Growth. Ad-vanced Macroeconomics (Fourth ed.). New York:McGraw-Hill. pp. 101149. ISBN 978-0-07-351137-5.

9 External links Economic Growth by Paul Romer. New Growth Theory, Technology and Learning: APractitioners Guide, U.S. Economic DevelopmentAdministration.

Technological Implications of New Growth Theoryfor the South, United Nations Development Pro-gramme.

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Models in Endogenous Growth The AK Model Endogenous versus exogenous growth theory Implications Criticisms See also Notes Further reading External links Text and image sources, contributors, and licensesTextImagesContent license