Endogenous growth theory

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In economics, endogenous growth theory or new growth theory was developed in the 1980s as a response to criticism of the neo-classical growth model.

In neoclassical growth models, the long-run rate of growth is exogenously determined by assuming a savings rate (the Solow model) or a rate of technical progress. This does not explain the origin of growth, which makes the neo-classical model appear very unrealistic. Endogenous growth theorists see this as an over-simplification.

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.

Endogenous growth theory demonstrates that policy measures can have an impact on the long-run growth rate of an economy. In contrast, with the Solow model only a change in the savings rate could generate growth. Subsidies on research and development or education increase the growth rate in some endogenous growth theory models by increasing the incentive to innovate.

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 compeition 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 over. 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.

[edit] Critics

One of the main failings of this (group of) theories is the collective failure to explain non-convergence. That is, to explain why some countries are still much richer than others. It is widely felt^[1] 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).

[edit] Trivia

In a 1994 speech the then Labour Party Shadow Chancellor Gordon Brown referred to post neo-classical endogenous growth theory, a phrase (humorously) commented on by Michael Heseltine as being the product of his special adviser Ed Balls showing off, by saying "It's not Brown, it's balls"

[edit] Notes

1. ^ See for instance, Professor Stephen Parente's 2001 review, The Failure of Endogenous Growth (Online at the University of Illinois at Urbana-Champaign). (Published in Knowledge Technology & Policy Volume XIII, Number 4.)