Endogenous growth theory — a very short introduction

23 Sep, 2013 at 08:57 | Posted in Economics | 4 Comments

shawIf you have an apple and I have an apple and we exchange these apples then you and I will each have one apple.

But if you have an idea and I have an idea and we exchange these ideas, then each of us will have two ideas.

George Bernard Shaw

Adam Smith once wrote that a really good explanation is “practically seamless.” Is there any such theory within one of the most important fields of social sciences – economic growth?

In Paul Romer’s Endogenous Technological Change (1990) knowledge is made the most important driving force of growth. Knowledge (ideas) are presented as the locomotive of growth — but as Allyn Young, Piero Sraffa and others had shown already in the 1920s, knowledge is also something that has to do with increasing returns to scale and therefore not really compatible with neoclassical economics with its emphasis on decreasing returns to scale.

Increasing returns generated by non-rivalry between ideas is simply not compatible with pure competition and the simplistic invisible hand dogma. That is probably also the reason why neoclassical economists have been so reluctant to embrace the theory wholeheartedly.

Neoclassical economics has tried to save itself by more or less substituting human capital for knowledge/ideas. But knowledge or ideas should not be confused with human capital. Although some have problems with the distinction between ideas and human capital in modern endogenous growth theory, this passage gives a succinct and accessible account of the difference:

Of the three statevariables that we endogenize, ideas have been the hardest to bring into the applied general equilibrium structure. The difficulty arises because of the defining characteristic of an idea, that it is a pure nonrival good. A given idea is not scarce in the same way that land or capital or other objects are scarce; instead, an idea can be used by any number of people simultaneously without congestion or depletion.

Because they are nonrival goods, ideas force two distinct changes in our thinking about growth, changes that are sometimes conflated but are logically distinct. Ideas introduce scale effects. They also change the feasible and optimal economic institutions. The institutional implications have attracted more attention but the scale effects are more important for understanding the big sweep of human history.

The distinction between rival and nonrival goods is easy to blur at the aggregate level but inescapable in any microeconomic setting. Picture, for example, a house that is under construction. The land on which it sits, capital in the form of a measuring tape, and the human capital of the carpenter are all rival goods. They can be used to build this house but not simultaneously any other. Contrast this with the Pythagorean Theorem, which the carpenter uses implicitly by constructing a triangle with sides in the proportions of 3, 4 and 5. This idea is nonrival. Every carpenter in the world can use it at the same time to create a right angle.

Of course, human capital and ideas are tightly linked in production and use. Just as capital produces output and forgone output can be used to produce capital, human capital produces ideas and ideas are used in the educational process to produce human capital. Yet ideas and human capital are fundamentally distinct. At the micro level, human capital in our triangle example literally consists of new connections between neurons in a carpenter’s head, a rival good. The 3-4-5 triangle is the nonrival idea. At the macro level, one cannot state the assertion that skill-biased technical change is increasing the demand for education without distinguishing between ideas and human capital.



  1. Romer, in my view, has veered off into la-la land with his Mega cities – seems a lot like concentrated human capital idea run amok!!!

    • Maybe — but on a theoretical level there’s a large and extremely important difference between knowledge/ideas and human capital!

  2. I agree with you. Ironically, the human capital suffers from its own endogeinity problem. This is a major problematique in Howitt’s work and Phelps is all over the place with how to square the two.

  3. When browsing through the internet and looking through the economic debate, I discovered and
    Remembered Gorden Brown’s conference speech on economics and most famously the
    announcement with some amusement from some quarters hitherto ‘post neo-classical endogenous growth theory’, a modern version of the endogenous growth theory rebranded much the same of the Labour party as New Labour under the stewardship of Blair and Brown. But what is this ‘theory’ about, with a little curiosity I came across a book by Kreps and Wallis (Wallis and grommet!) and read a sample from the internet and even went on to order the book through Amazon.

    Having read the chapter by Professor Crafts, it suddenly dawned on me that it is but one important
    Theory re-emerging recently in the 80’s based on technological advancement and with it potential
    Growth. I will explain why this is a theory that must be borne in mind set across many other
    Theoretical factors with a culminated effect creating a competition between theorists in convincing
    Institutions and governments in exploring alternatives to a particular economic position.

    Since the industrial revolution in the UK which saw growth and advancement in industry patented
    and commence with huge feats of engineering and micro-inventions resulting in increase in productivity and labour, with it produced growth for the nation with an empirical market in which
    to export goods and services- though not clear from this era as to the productivity rate of labour per
    Class, but it is clear child labour was ripe accounting much of the labour productivity. However, with
    the decline of the empire and therefore market size, the Victorian era reversed this endogenous growth with other industrial nations taking on the mantra of endogenuity with advancement of technology with integrated market most notably the US. Therefore this period saw a change of shift from the UK as innovator to the US with a clear purpose based on size of market, demand, surplus labour and with it came a change from physical capital to intangible capital most notably in the mass production of model T Ford car. It is also noticeably that the US had one of the highest rates of increase in college education, a rise in commerce and market activity. Yet, it is also clear the 1930’s saw the Great Depression created through a loss of confidence in the markets resulting in international repercussions as well as a disintegration of society.

    This theory can also be seen to have succeeded in the so called ‘golden era’ of growth namely between the post war years of 1950 to 73 that transformed society and with it produced growth, and again most recently we have seen unprecedented growth in the 80’s with rising business, innovation, market activity, housing boom to the reach of ordinary people.

    In the present time again we have seen throughout the international community advancement in ever innovative and faster technology, with rise in productivity, rise in labour markets and activity making everyday tasks easy and easier. However, the question posed is why then have we seen decline in industrial and endogenous growth as a nation and beyond. Curiously the same is true of other leading nations far in advance in terms of technology and market size which are in decline in ‘growth’ the US, EU, Japan, Asia needing help from other nations and bailouts from the nation and international communities through loans provided by the IMF. The answer must be that technology is simply not enough to account for a nation’s well being if the sole object or barometer of success is viewed through one economic lens of ‘growth’. Further, we can also question whether advance in innovation, technology benefits all as there seems to be a huge gap in our country between those who still do not have access to basic technology such as a computer, cell phone, car namely through lack of education, age group and socio-economic factors, thereby creating a gap between those who have and those who do not, this gap has rippling effect on individual productivity and output, access to job market and so on all contributing cumulatively to economic mass loss in potential growth for the nation, in turn this lack of advancement and movement out of tune with other groups mean time to train, teach, learn again affecting future growth.

    This simplest of observation neither reveals that no one theory can be discounted nor be a predominant theme in any economic policy seeking as an objective economic well being or growth. It is also important to also understand that one theory cannot usurp demand for all sections of the populace (as no time will we have same age groups) with competitions between groups nor can it be accountable to bridge gaps in people’s expectations, advancement and productivity. It is evidently clear that to produce meaningful growth that is sustained, flexible and purposeful then resources need to be amassed; all sections of the community (cultures) need to be advance together as one accounting for new technology and innovation through education, mutual support most notably from institutions and government since breakdown in the chain of productivity affects a nations growth potential producing a side effect of untold damage.

    What is the solution then, the simplest answer is for a nation to work and stand together as it advances in the modern and future era to come, take account of technology and innovation of change in society populace, economic shifts producing a integrated market place for which to produce and work together for the national good through individual, community endeavour and spirit with freely available network of support, building for the present and future needs. A society that is flexible, educated, adapts to changes quickly is a society that is integrated with opportunities for all is a society that is advanced able to take on challenges together as a nation and with it rekindle the spirit of work innovators transforming and shaping the world outside these shores. In essence this model calls for mapo-economics (Ormerod) devising a nations economic policy reflected on its assets, resources, labour much the same way as a tailor cutting a coat according to its cloth increasing in supply to demand and market.

    At the beginning I explained that endogenous growth theory can yet be one theory from many other important and historical theories that equally account for growth such as fiscal, monetary, macro-economics, Keynesian and so on. No one theory then can account for growth, if the premise is correct then it follows we need to evaluate and apply a given theory and theories yet to surface whether singly or mixture. The best analogy that I can draw of this economic disposition is akin to a football Manager with his coaches (Government, Institutions) in charge of a team of players (economic theorists/ theory) each with individual skills and abilities but playing in different roles (economic cycle, shortage, and deficit) yet working together in building a good team being able to take on any challenges with the end result of achieving a goal for the team and all its supporters (all people). In short economics does not have to mean economic football.

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