Endogenous Growth Theory


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Research technology exhibits diminishing returns which means that investments in research technology will not double knowledge. Moreover, the firm investing in research technology will not be the exclusive beneficiary of the increase in knowledge. The other firms also make use of the new knowledge due to the inadequacy of patent protection and increase their production.

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Thus the production of goods from increased knowledge displays increasing returns and competitive equilibrium is consistent with increasing aggregate returns owing to externalities. Thus Romer takes investment in research technology as endogenous factor in terms of the acquisition of new knowledge by rational profit maximisation firms. Uzawa developed an endogenous growth model based on investment in human capital which was used by Lucas. Lucas assumes that investment on education leads to the production of human capital which is the crucial determinant in the growth process. He makes a distinction between the internal effects of human capital where the individual worker undergoing training becomes more productive, and external effects which spillover and increase the productivity of capital and of other workers in the economy.

It is investment in human capital rather than physical capital that have spillover effects that increase the level of technology. Thus the output for firm i take the form. Where A is the technical coefficient, K i and H i are the inputs of physical and human capital used by firms to produce goods Y i. In the Lucas model, each firm faces constant returns to scale, while there are increasing returns for the whole economy.

Further, learning by doing or on-the-job training and spillover effects involve human capital. Each firm benefits from the average level of human capital in the economy, rather than from the aggregate of human capital. Thus it is not the accumulated knowledge or experience of other firms but the average level of skills and knowledge in the economy that are crucial for economic growth. In the model, technology is endogenously provided as a side effect of investment decisions by firms.


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Technology is treated as a public good from the point of view of its users. As a result, firms can be treated as price takers and there can be equilibrium with many firms as under perfect competition. This sector invokes human capital alongwith the existing stock of knowledge to produce ideas or new knowledge.

Endogenous Growth: Analytical Review of its Generating Mechanisms

To Romer, ideas are more important than natural resources. He cites the example of Japan which has very few natural resources but it was open to new western ideas and technology. It imported machines from the United States during the Meija era, dismantled them to see how they worked and manufactured their better prototypes. Therefore, ideas are essential for the growth of an economy. These ideas relate to improved designs for the production of producer durable goods for final production.

In the Romer model, new knowledge enters into the production process in three ways. First, a new design is used in the intermediate goods sector for the production of a new intermediate input. Second, in the final sector, labour, human capital and available producer durables produce the final product.

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Third, and a new design increases the total stock of knowledge which increases the productivity of human capital employed in the research sector. Market incentives play an important role in making technological changes available to the economy.


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Knowledge or a new design is assumed to be partially excludable and retainable by the firm which invented the new design. It means that if an inventor has a patented design for a machine, no one can make or sell it without the agreement of the inventor. On the other hand, other inventors are free to spend time to study the patented design for the machine and acquire knowledge that helps in the design of such a machine.

Nobel laureate Paul Romer’s contribution to endogenous growth theory

Thus patents provide incentives to firms to engage in research and development, and other firms can also benefit from such knowledge. When there is partial excludability, investment in research and development leading to an invention by a firm can only bring in quasi-rent. The new design can be used by firms and in different periods without additional costs and without reducing the value of the input. Romer on the other hand advocated for a proactive government policy. In the presence of externalities, market return to knowledge creation would differ from its social return which, according to Romer, necessitates government intervention.

The role of the government in this context would entail creating the right incentives for private agents to engage in research. In particular, it paid scanty attention to perhaps the most significant aspect of knowledge creation, namely that it is an outcome of private initiatives. Private agents operate on profit motives. Yet monopoly profits from knowledge creation cannot be sustained under perfect competition.

The primary shortcoming of Romer was that it could not completely break away from the neoclassical tradition: it retained the assumption of a perfectly competitive market structure.

Romer’s endogenous growth theory could provide a solution for global problems

This implied that private initiatives in knowledge creation would not be fully rewarded either at present due to externality or in future competition ruled out any scope for future profits. In fact, the difference between the two then becomes a matter of semantics. The line of argument linking profit-driven private endeavours to technological progress, which was initiated in Romer but left somewhat unexplored, was finally brought to a closure in a follow-up paper of Romer that introduced imperfect competition, thereby allowing private firms to earn monopoly profits from knowledge creation.

In this paper, Romer modelled technological innovations and knowledge creation in the form of expanding varieties of new products. New ideas would translate into new products.

What is endogenous growth theory? definition and meaning - cydulylomi.tk

Patenting made knowledge creation excludable and ensured the existence of monopoly profits over long run. At the same time, knowledge being non-rival in nature, existing stock of knowledge could be readily used by potential producers of newer varieties. Long-run growth happened in this model due to gains from specialisation through introduction of newer varieties as well as spillover effects in research that effectively reduced the marginal cost of new innovations.

To be sure, product variety models set in a monopolistically competitive market structure made their appearances in the literature before for example, Spence , Dixit and Stiglitz , and Ethier But to integrate this framework to a decentralised, market-driven mechanism of innovation and knowledge creation that could endogenously explain sustained technological change was a remarkable achievement indeed.


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By directing our attention towards the role of private initiative in technological innovations and inventions, and the concomitant incentive issues, Romer has brought to the fore a tension implicit in modern technology-driven growth process. On the other hand, any monopoly power essentially entails an efficiency loss. In this context, designing the optimal government policy itself is a challenging issue. The timing of the award is curious though. Mausumi Das Delhi School of Economics mausumi econdse.

kindbricfoxtre.tk Published: European Economic Review 36, pp. Development of the American Economy. Economic Fluctuations and Growth. International Finance and Macroeconomics. International Trade and Investment.

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