Endogenous growth theory suggests that technological change is driven by economic incentives and can be augmented by investment in human capital and intellectual property protections. It also implies that government and private sector policies can have a long-term impact on growth.
An endogenous growth theory is the type of theory developed primarily by economist Paul Romer and his University of Chicago doctoral adviser, Robert E. Lucas. It is a response to criticisms of neoclassical models of economic growth that assumed that technological change was exogenously driven, leading to the pessimistic conclusion that government and market policies could do nothing to increase long-term economic growth. An endogenous growth theory suggests that technological change is a response to economic incentives in the market that may be created and/or influenced by governmental or private sector institutions.
Neoclassical models of growth have failed to answer some basic economic questions, particularly about differences in economic growth and quality of life between developed and developing countries. If technological change was truly exogenous and freely available to all, the only way rich countries should have such dramatically higher living standards is if poor countries have significantly less capital and a huge rate of return for additional investment. . If that were the case, there should be huge flows of capital from rich countries to poor countries and an equalization of living standards, but in reality there is none.
In endogenous growth theory, technological change is a function of the production of ideas. New ideas lead to new and better goods as well as better manufacturing techniques and higher quality older goods. Technological change can then be augmented by providing monopoly power through patents and copyrights to accelerate the pace of innovation.
The second way technological change can be augmented is through investment in human capital, which is the sum of all human knowledge in a nation. Through education, training, and other investments in human capital, a country can increase worker productivity and boost economic growth. Endogenous growth theory also predicts that the spillovers from investment in value-added products and knowledge will itself constitute a form of technological progress and lead to higher growth.
There are several policy implications of the endogenous growth theory. First of all, it is the conclusion that politics and institutions matter and can have an impact on growth. Rather than countries having to wait for exogenous technological advances to occur or be limited to short-term increases in growth resulting from policy-induced increases in the savings rate, endogenous growth theory suggests that government and private sector policies can have a long-term medium-term growth effect.
A poor country with little human capital cannot become rich simply by acquiring more physical capital, so investment in human knowledge through worker education and training programs is a key to achieving growth. Similarly, government policies that increase the incentive to innovate can also lead to higher growth rates. Such policies could include items such as subsidies for research and development and strengthening intellectual property protections.
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