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. In other words, it is determined outside of the model, generally by an assumed rate of technological progress and an assumed rate of labor force growth. 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 endogenizing the rate of technological progress. Several competing models have been developed by various authors. Endogenous growth theories usually rely on virtuous cycles. Crucial importance is usually given to the "production" of new technologies and human capital. Firms and individuals have an incentive to invent in order to exploit an advantage over their competitors, thereby improving their own productivity. Some of the knowledge associated with the innovation "spills over" to other economic actors, which increases those actors' ability to innovate. The virtuous cycle arises through this mechanism.
In contrast to the older neoclassical growth theory, endogenous growth theory argues that policy measures can have an impact on the long-run growth rate of an economy, even if they do not change the aggregate savings rate. The neoclassical model implies that changes in the savings rate will not affect economic growth, but they will increase income levels. Under the neoclassical model, if savings rates change, the growth rate in output will adjust so that it will be at the level it was at before the change in savings rates. The endogenous growth theory assumes constant marginal product of capital. The endogenous growth theory also implies that '''higher savings levels will lead to higher economic growth.
According to the endogenous growth theory, as income increases, what happens to the gap between savings and required investment? Since the savings curve is a straight line (as opposed to the neoclassical model where the savings curve is curved), it is always greater than the required investment curve. Since the gap determines the rate of growth in the capital-labor ratio, the endogenous growth model predicts that high income will lead to high savings and high savings will lead to high growth rates.
The endogenous growth theory assumes constant marginal product of capital. This implies that larger firms will be efficient. It goes so far as to imply that only one firm (an ultra efficient monopoly) should exist.
'Subsidies on research and development or education increase the growth rate in some endogenous growth theory'' models by increasing the incentive to innovate.
The most significant theoretical differences to the neoclassical growth theory stem from discarding the neoclassical assumption of diminishing marginal returns to capital investments. This assumption would permit increasing returns to scale in aggregate production, and is frequently focusing on the role of externalities in determining the rate of return on capital investments.
Scottish Labour Party politician Gordon Brown once referred to post neo-classical endogenous growth theory in a speech. This was (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".
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[#endnote_Critics] 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).
Notes
↑ 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.)
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