Endogenous Growth Theory: Definition, History, and Criticism

What is Endogenous Growth Theory?

Endogenous growth theory is an economic theory which argues that economic growth is generated from within a system as a direct result of internal processes. More specifically, the theory notes that the enhancement of a nation's human capital will lead to economic growth by means of the development of new forms of technology and efficient and effective means of production.

Understanding Endogenous Growth Theory

The endogenous growth theory offered a fresh perspective on what engineers economic growth. It argued that a persistent rate of prosperity is influenced by internal processes such as human capital, innovation, and investment capital, rather than external, uncontrollable forces, challenging the view of neoclassical economics.

Endogenous growth economists believe that improvements in productivity can be tied directly to faster innovation and more investments in human capital. As such, they advocate for government and private sector institutions to nurture innovation initiatives and offer incentives for individuals and businesses to be more creative, such as research and development (R&D) funding and intellectual property rights.

The idea is that in a knowledge-based economy, the spillover effects from investment in technology and people keep generating returns. Influential knowledge-based sectors, such as telecommunications, software, and other high-tech industries, play a particularly important role here.

Central tenets to endogenous growth theory include:

• Government policy's ability 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, health, and telecommunications.
• Private sector investment in R&D is a crucial source of technological progress.
• The protection of property rights and patents is essential to providing incentives for businesses and entrepreneurs to engage in R&D.
• 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.

History of Endogenous Growth Theory

Endogenous growth theory emerged in the 1980s as an alternative to the neoclassical growth theory. It questioned how gaps in wealth between developed and underdeveloped countries could persist if investment in physical capital like infrastructure is subject to diminishing returns.

Economist Paul Romer put forward the argument that technological change is not just an exogenous byproduct of independent scientific developments. He sought to prove that government policies, including investment in R&D and intellectual property laws, helped foster endogenous innovation and fuel persistent economic growth.

Romer previously complained that his findings hadn’t been taken seriously enough. However, he was awarded the 2018 Nobel Prize in Economics for his studies on long-term economic growth and its relationship with technological innovation. His concepts are also regularly discussed by politicians when they debate ways to stimulate economies.

Criticism of Endogenous Growth Theory

One of the biggest criticisms aimed at the endogenous growth theory is that it is impossible to validate with empirical evidence. The theory has been accused of being based on assumptions that cannot be accurately measured.