What is Endogenous Growth Theory?
The endogenous economic theory states that internal factors are responsible for a nation’s economic development, not external factors. When the government and the private sector invest in human capital, innovation, and knowledge, the nation’s productivity is enhanced.
This theory was in opposition to Solow Swan’s neoclassical economics. Neoclassical economics considered exogenous forces like supply and demand as the key factors behind productivity, consumption, and pricing. The theory often gets criticized for relying too much on inaccurate assumptions; there is no empirical evidence to prove the model’s validity.
Table of contents
- Endogenous growth theory proposes that economic growth occurs due to internal factors like human capital, innovation, and knowledge and is not driven by external forces like a physical investment.
- Based on the endogenous theory, three growth models were formulated—the Arrow model, Uzawa-Lucas model, and Romer model.
- This principle considers physical and human capital as separate factors. However, for many real-world applications, a demarcation between external and internal factors cannot be drawn.
Endogenous Growth Theory Explained
The endogenous growth model states that the economic growth of any nation is an outcome of internal factors like human capital, knowledge, and innovation. This principle stresses internal factors and not exogenous forces.
This school of thought believes that governments and private sector enterprises should work on endogenous elements contributing to research and developmentResearch And DevelopmentResearch and Development is an actual pre-planned investigation to gain new scientific or technical knowledge that can be converted into a scheme or formulation for manufacturing/supply/trading, resulting in a business advantage.. This will lead to technological advancement and a rise in productivity in the long run.
The origin of endogenous growth theory can be traced back to the 1980s. Economists back then opposed Solow Swan’s neo-classical growth model. The neo-classical model disregarded the impact of exogenous forces on economic development. The exogenous growth model highlighted the role of physical capital investments and infrastructure (exogenous factors) in causing a gap between developed nations and under-developed nations.
But Paul Romer stated that investments made in R&D foster innovation and technological change over a period and thus are a key influence behind economic growth.
Now you can Master Financial Modeling with Wallstreetmojo’s premium courses at special prices
Best Financial Modeling Courses by Wallstreetmojo
Financial Modeling Course
* 12+ Hours of Video
Financial Modeling & Valuation
* 25+ Hours of Video
* Certificate of Completion
* 12+ Hours of Video
The endogenous growth principle makes the following assumptions:
- The government and private sector can ramp up technical progress by investing in research and development programs.
- The government should mold entrepreneurship to support innovation, capital investmentCapital InvestmentCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc., and job creation.
- Considerable investments should be made in learning and training programs—to enhance productivity and human capital. Such an investment offers a return to scale.
- Return to scale refers to a scenario where an increase in inputs is less, but the increase in production output is considerably more.
- Investing in technological advancement (optimization of the manufacturing process) increases productivity.
- Entrepreneurs and businesses that opt for R&D get incentives in the form of intellectual property rights—copyrights and patents.
The endogenous theory has proposed various growth models, as discussed below:
#1 – Arrow Model
The arrow model, or AK model, was first developed in 1962 by Arrow and Frankel. This economic model recognizes technology and innovation as key forces that drive the economic growth of a nation. This theory emphasizes the practice of ‘learning by doing’ to enhance human capital, productivity, and innovation. It is denoted by:
Y = AK
- A is a constant positive value.
- K is the aggregate capital stock.
- Y is proportional to K.
#2 – Uzawa–Lucas Model
In 1965, Uzawa proposed an endogenous growth model that narrowed down on human capital investments—causing long-term growth in an economy. Further, in 1988, Lucas contributed to the idea that investing in education is necessary for increasing the productivity of human capital. Lucas proposed internal training of workers (to improve production).
The Uzawa-Lucas Model is presented as follows:
Yi = A(Ki) x (Hi) x He
- A resembles the technical coefficient.
- Ki is the physical capital.
- Hi is the human capital.
- He denotes the economy’s average level of human capital.
#3 – Romer Model
In 1990, Paul Romer introduced Endogenous Technological Change in the Journal of Political Economy. Romer stated long-run growth results from the contribution of entrepreneurs and researchers in the form of innovation and technological advancement. He, too, stressed the importance of new ideas, learning, and knowledge in economic growth. Further, he believed that the government should support and play a crucial role in appreciating innovative ideas.
The technological production function given by Romer is as follows:
∆A = F (KA, HA, A)
- ∆A is the increasing technology.
- F is the production function for technology.
- KA denotes the capital investment in developing the new technology.
- HA is the human capital used for research and the development of new ideas.
- A is the current technology.
Many economists oppose this theory on the following grounds:
- Due to the lack of empirical evidence in favor of the endogenous growth theory, it cannot be considered a proven model.
- Also, this theory depends upon various assumptions; the assumptions often seem vague or inaccurate for real-world applications.
- It considers physical and human capital as two different factors: one is external, and the other is internal. However, some critics believe there is no difference between these two forces.
Frequently Asked Questions (FAQs)
Following are the five recent theories of economic development:
1. Baran’s Neo-Marxism
2. Dependency Theory
4. Solow’s Neoclassical Theory
5. Endogenous Growth Theory
The three essential factors or elements responsible for the endogenous growth of the economy are:
1. Human Capital
The majority contribution to economic growth and higher productivity comes from internal forces and not external factors. Internal factors require private and government investment in human capital, knowledge, and innovation. Thus, technical progress becomes endogenous when governments and private companies invest in R&D to develop new ideas.
One of the criticisms of the endogenous growth model is that it relies too much on assumptions. These assumptions may not stand true—there is a lack of empirical evidence. Also, it ignores the contribution of organizations to economic growth. It considers only human capital as a key factor. In real-world scenarios, It is difficult to distinguish between physical and human capital.
This has been a guide to what is Endogenous Growth Theory. We discuss Endogenous Growth Theory definition, meaning, assumptions, limitations & growth models by Paul Romer, & Solow Swan. You can learn more about it from the following articles –