Endogenous growth theory

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In economics, endogenous growth theory or new growth theory was developed in the 1980s^[1][2] as a response to criticism of the neo-classical growth model. The endogenous growth theory 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 innovate.

In neo-classical growth models, the long-run rate of growth is exogenously determined by either assuming a savings rate (the Harrod–Domar model) or a 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 foundations. 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, 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.

Implications

The main implication of recent growth theory 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 Howitt notes:

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).

Critics

One of the main failings of endogenous growth theories is the collective failure to explain conditional convergence reported in the empirical literature.^{[citation needed]} Another frequent critique concerns the cornerstone assumption of diminishing returns to capital. Some contend^[3] that new growth theory has proven no more successful than exogenous growth theory in explaining the income divergence between the developing and developed worlds (despite usually being more complex).

See also

• Economic growth
• Human capital
• Paul Romer

Notes

External links

• Economic Growth by Paul Romer.
• New Growth Theory, Technology and Learning: A Practitioner's Guide, U.S. Economic Development Administration.
• Technological Implications of New Growth Theory for the South, United Nations Development Programme.