Endogenous Growth: What it Means, How it Works, Theory

What Is Endogenous Growth?

Endogenous growth theory is a macroeconomic growth theory that emphasizes the importance of the improvement of factors internal to an economy and a country's population.

Understanding Endogenous Growth

Endogenous growth theory focuses on the role that population growth, human capital, and the investment in knowledge play in generating macroeconomic growth, rather than exogenous factors where technological and scientific process are independent of economic forces.

Endogenous growth theory stands in contrast to classical growth theory and neoclassical growth theory, which focus more on natural resource endowments, accumulation of capital, and gains from specialization and trade, and the adoption of new technologies exogenous to the economy, respectively. Accordingly, in endogenous growth theory, population growth and innovation have more impact on growth than physical capital.

Endogenous growth theory has not redefined the concept of economic growth, but offers additional complexity to the explanation for the sources of growth and the prescriptions for enhancing growth.

Endogenous growth theory emerged in the 1980s, as an extension of neo-classical growth theory. In their 1992 paper, "A Contribution to the Empirics of Economic Growth", economists David Romer, Gregory Mankiw, and David Weil developed endogenous growth theory using the same basic framework as neo-classical theory. They aimed to explain how differences in wealth between developed and underdeveloped countries could persist, if investment in physical capital like infrastructure is subject to diminishing returns. Such differences should disappear over time, if productivity growth is determined exogenously by factors outside its control, as neo-classical models assume.

Endogenous growth theory resolves this challenge by assuming that technological progress is not exogenous to the economy, but is determined by the level of human capital and investment in new human capital over time. By augmenting neo-classical growth theory with human capital, Mankiw, Romer, and Weil provided a plausible explanation for the observed failure of developing economies to converge with more developed economies over the course to the 20th century.

Endogenous models thus show that the key determinants of economic growth are the accumulation of human capital, population growth and knowledge. In a knowledge-based economy, supported by robust intellectual property rights, there are no diminishing returns to capital accumulation thanks to positive spillover effects from investment in technology and people. Productivity growth is determined by differences in spending on R&D and education in endogenous models. And this feeds back into faster technological progress. In other words, superior economic growth can be cultivated.

The reasons some countries grow faster than others remain mysterious. But the concept of endogenous technological change is relevant to population growth and technological adoption in places like Africa, and can help us understand the economic impacts of aging populations in Europe, Japan and China. Economies have to ceaselessly transform themselves and develop, if they are to enjoy continued prosperity and become more productive.

Endogenous Growth Theory

The central tenets of endogenous growth theory include:

• Government policies are able to raise a country’s growth rate if they lead to more intense competition in markets and help to stimulate product and process innovation.
• There are increasing returns to scale from capital investment especially in infrastructure and investment in education and health and telecommunications.
• Private sector investment in research & development is a key source of technological progress
• The protection of property rights and patents is essential to providing incentives for businesses and entrepreneurs to engage in research and development.
• Investment in human capital is a vital component of growth.
• Government policy should encourage entrepreneurship as a means of creating new businesses and ultimately as an important source of new jobs, investment and further innovation

Critics argue endogenous growth models are nearly impossible to validate by empirical evidence.