Endogenous Growth Model

T H E O R I E S O F G R O W T H A N D D E V E L O P M E N T
PREFACE
The business world is very dynamic. What is best for today is worst tomorrow. So,
the modern business students need to change and update them according to the
current market conditions.
Various universities and business schools are arranging various modern programs that
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While preparing the presentation and the report, we have tried heart and soul to
remove all the mistakes possible. But nobody is free from mistakes as well as we are.
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……………………………..
Asadul Hoque
(President, 12 Knights)
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Web-site: http://aleaf.uuuq.com/12knights.html
Endogenous Growth Model

1
WHO WERE BEYOND THIS?
Name ID No. Position

Mohammad Asadul Hoque Lokman 07303112 President
Md. Ashiqur Rahman 07303128 Vice-President
Atiqur Rahaman 07303083 Knight
Md Abu Bakkar Siddik 07303026 Knight
Asiful Hakim 07303025 Knight
Sharmin Tasmin Lucky 07303021 Knight
Mohammad Sohag Howlader 07303037 Knight
Md Ashique Rubaet 07303090 Knight
Md Ashraf Hussain Shakil 07303038 Knight
Anwar Hussain Mamun 07303086 Knight
Chowdhury Mohammad Ariful Mostafa 07303041 Knight
Mohammad Selim Jahan 06303131 Knight

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TABLE OF CONTENTS
PREFACE ...................................................................................................................................................................1
WHO WERE BEYOND THIS? ..................................................................................................................................2
TABLE OF CONTENTS ............................................................................................................................................3
PART ONE: INTRODUCTION .................................................................................................................................4
Development Economics.......................................................................................................................................4
Growth and growth rate .......................................................................................................................................5
Growth vs. development .......................................................................................................................................6
PART TWO: THEORIES OF GROWTH..................................................................................................................7
Harrod-Domar Model ..........................................................................................................................................7
Neo-classical Model.............................................................................................................................................8
PART THREE: ENDOGENOUS GROWTH THEORY ......................................................................................... 10
Main theme ........................................................................................................................................................ 11
‘Endogenous theory’ or ‘the new growth theory’: the modern way of sustainable long-run growth ...................... 12
Assumptions of Endogenous Growth Theory ....................................................................................................... 12
The theory explanation ....................................................................................................................................... 13
How this theory is better than others?................................................................................................................. 15
Drawbacks......................................................................................................................................................... 15
REFERENCES.......................................................................................................................................................... 17

3
PART ONE: INTRODUCTION
A
s people throughout the world awake each morning to face a new day, they
do so under very different circumstances. Some live in comfortable homes
with many rooms. They have more than enough to eat, are well clothed and
healthy, and a reasonable degree of financial security.
Others, i.e. 3/4th of world’s population or six billion people, are much less fortunate.
They may have little or no shelter and an inadequate food supply. Their health is
poor, they often can not read or write, they are often unemployed, and their prospects
for a better life are uncertain at best.
This scenario is not new. Since the beginning of human civilization, the wall between
rich and poor exists. Various economists have developed various theories over the
economic development and growth to explain the reasons behind them and to solve
various economic problems of human being.
DEVELOPMENT ECONOMICS
Why these problems or big differences are happening?
Development Economics comes forward to explain it and it helps to find out the
solution.

4
Development economics is the study of fulfilling unlimited human wants by best

utilization of scarce resources and it emphasizes over the infrastructural development
as well. It involves the creation of theories and methods that aid in the determination
of policies and practices and can be implemented at either the domestic or
international level.
“Development Economics is a branch of economics which deals with economic aspects of the
development process in low income countries. Its focus is not only on methods of promoting
economics growth and structural change but also on improving the potential for the mass of the
population, through health and education and workplace conditions, whether through public or private
channels. Development economics involves the creation of theories and methods that aid in the
determination of policies and practices and can be implemented at either the domestic or international
level.”1
GROWTH AND GROWTH RATE
Increasing gross national product of a country in a particular time usually one year is
known as the growth. In an economy, national income increases if production
increases in one or more sectors. This increase of the national income is generally
considered as growth.
1
www.wikipedia.org

5
Growth rate equation2:
y1 − y 0
Growth = × 100
y0
Where,
y1 = Gross National Product of the current year
y0 = Gross National Product of the previous year
GROWTH VS. DEVELOPMENT
Though many of us think that the term ‘growth’ and ‘development’ are same, but they
are not. They have some significant differences between them. They are:
1. Increasing the production in one or more sectors of a country is known as

growth. On the other hand, economic development is long-tern process, by
which national income of a country increases continuously along with
infrastructural development like education, health, communication,
transportation, engineering and technology etc.
2. If there is a growth in a country, there may not be any development. But if

there is any development there must be an economic growth though
development is sometimes considered as the prerequisite of growth.
2
Macro Economics by Dr. Mohammad Liakot Ali Khan, 1st Edition, page no.- 594

6
PART TWO: THEORIES OF GROWTH
G
rowth indicated increase in production and national income. Various
variables are related with the national income growth. For example: if
growth rate increases, then production, employment, investment,
consumption increases and vice versa.
Keeping in a stable and expected position of various economic variables is the main
concern of today’s economic policy-makers. Therefore, many development theories
have been established so far. From those models, classical, neo-classical, Harrod-
Domar and Solow-Swan growth models are very popular. But these models are
backdated and have very significant limitations.
Before discussing about endogenous theory, we need to understand what others say.
HARROD-DOMAR MODEL
These two economists have presented their views mainly on behalf of the developed
countries. The main problems of developed countries are not development rather
keeping full employment stable. Therefore, that was the
main concern of Harrod-Domar model.
There are various assumptions, theories and approaches

that are used to explain the Harrod-Domar model. This is
a very interesting model, no doubt; but not free from
various limitations. Some of them are:
The model is based on the economy of

developed countries, not developing countries.
In this model, savings ratio and capital

formulation ratio are assumed to be constant.
But they fluctuate a lot.
The theory is based on ‘Laissez Faire’ Adam Smith

economy, where there will be no Govt. (Classical Economist)
interference. But in practical, pure Laissez

7
Faire doesn’t exist at all.
The model is dependent on savings and capital. But there are elements that
can influence the economic development. For instance, management,
administration, economic infrastructure etc.
And, the last one, it is not applicable in the developing countries like
Bangladesh, India, Sri Lanka and Pakistan.
NEO-CLASSICAL MODEL
By criticizing the Harrod-Domar, economists Robert Solo has developed a new

theory that is named as Neo-classical Solo model. Solo describes that Harrod-
Domar’s model has been established on the basis of full employment balance which
is very risky and unstable. He describes the model as ‘Knife Edge Problem’ where the
economy can face a big inflation and as well as stagflation, from where the economy
can never return back.
According to Solo, if capital production ratio and capital labor ratio is considered as
flexible, the economy will reach into a stable position automatically. 3
Just like other models, this is not free from any criticism.
They are:
The contribution is the net investment in the

expected growth rate and actual growth rate is
not clear in this model.
This model ignores the important term that what

should be the contribution of Govt. in an
economy.
And, the last one, it doesn’t provide any new

theory of development. It just solves the
problem of Harrod-Domar model. Roy F. Harrod
(1900-1978)
This theory emphasizes over technological
advancement, but it couldn’t show the exact determinants of the
technological progress.
This theory is based on diminishing marginal return, which only can

ensure a steady rate, not a long-run growth in the economy.
3
Macro Economics by Dr. Mohammad Liakot Ali Khan, 1st Edition, page no.- 607

8
There are various explanations over Harrod-Domar (Classical) and Solow-Swan

(Neoclassical) models that can be found in many development economics books.
Therefore, ignoring those explanations, we are going to explain our main concern i.e.
Endogenous Theory.

9
PART THREE: ENDOGENOUS GROWTH THEORY
E ndogenous means ‘internally derived’ or ‘without any external cause’. As we

have discussed earlier, the previous growth and development models are
based on some assumptions

that are confusing and these
theory can never ensure the
long-term sustainable growth
for an economy.
In countries on the leading

edge of technology, the
advance of knowledge is a key
determinant of growth.
Invention of new technology is
much less important for poorer
countries, because poorer
countries can grow by
“borrowing” technology, as Robert Lucas Paul Romer
well as by investing in physical and human capital. In this part, we shall examine how
society’s choices lead to technical progress- the subject called ‘Endogenous Growth
Theory’.
Economist Paul Romer and Robert Lucas are responsible for much of the early
development of this concept4. The theory was first established in the year, 1980.
Endogenous growth theory attempts to explain growth rates as functions of societal

decisions, in particular saving rates.
4
Macro Economics by Rudiger Dornbusch and others, Ninth Edition, page no: 77

10
MAIN THEME
The model defines that output and growth depend on the internal variable saving rate.
It is the saving rate that is converted into human capital investment (investment for
innovating new ideas and methods). It also holds that technological progress is
essential for economy’s long-run growth. But the determinant of the technological
progress is the saving rate.
Some important definitions

Some important definitions are needed to understand and keep in mind before the main
discussion of ‘Endogenous Growth Theory’. They are shortly discussed below:
Returns to scale5: Diminishing For example, if labor, land,

returns and marginal products refer capital, and other inputs are
to the response of output to an doubled, then under constant
increase of a single input when all returns to scale output would
other inputs are held constant. also double.
Sometimes we are interested in the Ψ Increasing returns to scale arise

effect of increasing all inputs. For when an increase in all inputs leads
example, what would happen to to a more than proportional
wheat production if land, labor, increase in the level of output.
water, and other inputs were
increased by the same proportion? Ψ Decreasing returns to scale occur
Or what would happen to the when a balanced increase of all
production of tractors if the inputs leads to a less than
quantities of labor, computers, proportional increase in total
robots, steel, and factory space output.
were all doubled? These questions
refer to the returns to scale, or the Spillover Effects6: Spillover effects
effects of scale increases of inputs which involve involuntary imposition
on the quantity produced. Three of costs or benefits. Market
important cases should be transactions involve voluntary
distinguished: exchange in which people exchange
goods or services for money. When a
Ψ Constant returns to scale firm buys a chicken to make frozen
denote a case where a change drumsticks, it buys the chicken from
in all inputs leads to a its owner in the chicken market, and
proportional change in output. the seller receives the full value of the
hen. When you buy a haircut, the
5 6
Economics, Eighteenth Edition, Economics, Eighteenth Edition,
Samuelson and Nordhaus, McGraw Samuelson and Nordhaus, McGraw
Hill Publication, page no: 111-112 Hill Publication, page no: 36

11
barber receives the full value for time, positive spillover effects for the rest of
skills, and rent. society. For example, researchers at
AT&T invented the transistor and
But many interactions take place launched the electronic revolution, but
outside markets. While airports AT&T’s profits increased by only a
produce a lot of noise, they generally small fraction of the global social
do not compensate the people living gains. In each case, an activity has
around the airport for disturbing their helped or hurt people outside the
peace. On the other hand, some marketplace; that is, there was an
companies which spend heavily on economic transaction without and
research and development have economic payment.
‘ENDOGENOUS THEORY’ OR ‘THE NEW GROWTH THEORY’: THE MODERN WAY OF SUSTAINABLE
LONG-RUN GROWTH
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’. The
Endogenous ‘Endogenous Growth Theory’ holds that policy measures can have an impact on the
Growth long-run growth rate of an economy. For example, subsidies on research and
development or education increase the growth rate in some ‘Endogenous Growth
Steady-state Models’ by increasing the incentive to innovate.7
output growth
determined by ‘Neoclassical Growth Theory’ dominated economic thought for three decades
endogenous because it does a good job of explaining much of what we observe in the world and
variables, for because it is mathematically elegant. Nonetheless, by the late 1980s dissatisfaction
example, the with the theory had arisen on both theoretical and empirical grounds. ‘Neoclassical
saving rate. Growth Theory’ attributes long-run growth to technological progress but leaves
unexplained the economic determinants of that technological progress. Empirical8
dissatisfaction developed over the prediction that economic growth and saving rates
should be uncorrelated in the steady state. The data make it clear that saving rates and
growth are positively correlated across countries.
ASSUMPTIONS OF ENDOGENOUS GROWTH THEORY
No population growth
No depreciation
Technological progress is essential
Increasing returns to scale
7
Source: www.wikipedia.org
8
Empirical means based on observation or experience rather than theory.

12
This model assumes that investment in education and research will not only have
positive effect on the firm or individual who is making the involvement, but also will
have on others of the entire economy.
THE THEORY EXPLANATION
The theory states that as the physical investment is subject to depreciation, so it can
only ensure a steady growth for a short period, not for a longer period due to
diminishing marginal return. If saving is invested into human capital, it will be
helpful to obtain a long-run growth.
This theory emphasizes education, knowledge, experience, research and training are
the sources of growth, because these things create a process of innovation.
Innovations are of two types:
Horizontal Innovation
Vertical Innovation
Horizontal Innovation: This innovation takes the form of developing new varieties
of goods through research. This creates a spillover effect over the economy.
How?
When a design is developed by a researcher, all others can see it. And, can more
rapidly develop additional designs. Then they can make this design as patent and can
sell to the immediate goods sector.9 When immediate goods sector buy this patent, it
has a monopoly power on each designs. It gives a monopoly market power to earn a
monopoly return. He enjoys these returns until another design is developed. This
makes a source of increasing rate of return.
This is the contribution of the ‘Research Sectors’.
Due to the research sectors, diminishing return is ruled out.
Vertical Innovation: This takes the form of improvements in existing products.

Innovation does create new product or technologies. This temporary increase in
output would increase productivity, generating a more sustain increase in output
growth.
So, it has been understandable that the new contribution of knowledge investment is
invented by one. But this benefit goes to the whole economy. Further, each new idea
makes the new next ideas possible. Therefore, the knowledge can grow
9
Immediate goods sector means a sector which only generates a food for production.

13
independently. That’s why; the investment in human capital can ensure a long-run
growth.
---------------
Contrast the following figure, where we have changed the assumed shape of the
production function to show a constant marginal product of capital. The production
function, like the parallel saving curve, is now a straight line. Since the saving curve
no longer flattens out, saving is everywhere greater than required investment. The
higher the saving rate, the bigger the gap of saving above required investment and the
faster is growth.
The economy described in the figure can be illustrated with a simple algebraic model
leading to endogenous growth. Assume a production function with a constant
marginal product of capital and with capital as the only factor. Specifically, let
Y = aK
That is, output is proportional to the capital stock. The marginal product of capital is
simply the constant a.
Assume that the saving rate is constant at s and that there is neither population growth
nor depreciation of capital. Then all savings go to increase the capital stock.
Accordingly,
∆K = sY = saK
Or,
∆K / K = sa
The growth rate of capital is proportional to the saving rate. Further, since output is
proportional to capital, the growth rate of output is:
∆Y / Y = sa
In this example, the higher the saving rate, the higher the growth rate of output.10
10
Macro Economics by Dornbusch and others, Ninth Edition, page no: 79

14
HOW THIS THEORY IS BETTER THAN OTHERS?
As we discussed earlier, various economists have been trying to ensure sustainable

growth for an economy. That’s why; they built lots of theories of which classical and
neo-classical growth model were very popular. But these theories had some
considerable limitations for which they couldn’t ensure the growth for a sustainable
longer period of time.
On the other hand, the endogenous model or new growth has been established to
remove the mistakes and limitations of the previous theories. As it is a modern theory,
can ensure for a sustainable growth for a long period of time, therefore, it is the most
successful economic growth theory ever made. The later version of this theory has
just been the modern reform, but the main theme is still the same.
DRAWBACKS11
As discussed earlier, it is the most successful economic development theory ever

built. But still it is not free from the limitations. Some significant limitations of this
theory have been provided below:
It is also based on some traditional neoclassical assumptions that are often

inappropriate for lower developing countries economies. For example: it
only considered single sector of production (agricultural, industrial).
It overlooked the influential factors that are applicable or possible in

limited sectors only as because of poor infrastructure, inadequate
institutional structures, and imperfect capital goods and markets.
11
Economic Development by Todaro and Smith, Eighth Edition, page no: 150

15
It is mainly concerned with long-run growth rather than short-run and

mid-run.
Though is has some significant limitations, but it is still the best and most
useful growth and development theory. It suits well in developed, developing
and underdeveloped countries as well.

16
REFERENCES
Books that have been used to prepare this report and as well as presentation:
Economics by Samuelson and Nordhaus, Eighteenth Edition

Economics by Dr. Liakot Ali Khan, 1st Edition
Macro Economics by Rudiger Dornbusch, Stanley Fischer and Richard
Startz, Ninth Edition
Economic Development by Michael P. Todaro and Stephen C. Smith,
Eighth Edition
The Economics of Development and Planning by M L Jhingan, 36th
Revised Edition
The web-sites that have been browsed during the collection of data are:
http://economics.about.com/cs/economicsglossary/g/endogenous_g.htm
econ.la.psu.edu/~bickes/endogrow.pdf
en.wikipedia.org/wiki/Endogenous_growth_theory
www.econ.umn.edu/~lej/papers/NeoclassicalHandbook.pdf
info.worldbank.org/etools/docs/library/.../KnowledgeGrowth-
PRWP3539.pdf
info.worldbank.org/etools/docs/library/.../KnowledgeGrowth-
PRWP3539.pdf
faculty.washington.edu/karyiu/confer/sea05/papers/lee_yu.pdf
arno.unimaas.nl/show.cgi?fid=135

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