Evaluation of Endogenous Growth Theory from a Critical Perspective

Endogenous growth theory (or new growth theory) is a new approach in the
economics literature which has started to develop in 1980s as a response to neoclassical
theory of growth. As Solow model had been a source of policy implementations for 1960s and
1970s; various policy makers started to adopt policies compatible with the new growth theory
starting after the path breaking paper of Romer (1986). In the following paragraphs, I will try
to evaluate the endogenous growth theory from a critical standpoint.
The birth of the endogenous growth theory depends on the criticism of neoclassical
theory of growth. In the Solow growth model, it has been predicted that an economy will
eventually reach its steady state level of income. The main reason behind that argument lies in
the concept of diminishing returns to capital and labour. In addition to capital and labour,
Solow also incorporated another variable called Solow residual (i.e. total factor productivity)
which is an exogenous variable representing advances in the technology and responsible from
the all kinds of increases in output except from the capital and/or labour increase. Solow
called that variable residual because it was calculated by the information from other factors
and outputs growth. In that sense, technology (or information in a broader sense) was an
exogenous variable. Before, the study of Romer (1986, 1990); Arrow (1962) presented a
different analysis with building up a model in which technology (or science) is used
endogenously and in a passive manner with learning by doing. However his theory was not
incorporating scientific investments (such as R&D) made by private firms. A more realistic
model which takes technology as endogenous also and incorporates R&D investments made
by competing firms has been developed later on in Romers work.
In the new endogenous growth theory, that Romer (1986, 1990) presents, science (or
information) has a crucial role in explaining the growth performances of countries. Since
science is a public good and can be acquired and used costlessly, technology will have a
positive effect in the production process. That is to say, unlike capital or labour, there is
increasing returns to technology. In this way, the new growth theory draws a more optimistic
picture than that of exogenous growth model.
In the setup of his model, Romer (1986) defines ideas (i.e. designs) as non-rival and
partially excludable goods. That is to say, everybody can use the formula of an industrial
product to produce it without affecting other individuals chance to do the same (non-rivalry).
However, innovative firms may use patents and licences to restrict other agents use of that
idea at least for a limited time (partially excludable). However when some people are
excluded from ideas, a reduction in the welfare of society occurs. Thus, a reasonable social
preference would be to allow people to utilize innovated ideas if they are non-rival. That
result leads to a problem: if the ideas generated by innovative firms for a certain cost can be
used costlessly by the other members of the society; then there is no incentive for those firms
to produce new ideas. In that case, there are two alternatives to handle this problem: either
science should be produced as a public good by government or the government should give
subsidies to innovative firms to ensure the production of new ideas.

As I have put forward earlier, various policymakers around the world (including
USA and British governments) have tended to implement policies in line with the advice of
the new growth theory. Those efforts included a bigger share in fiscal expenditure for the
investment in technology and expended budgets for academic science. However, as AlUbaydli and Kealey (2000) argue, those economies of USA or Britain do not prosper with the
help of those policies; instead they flourish in spite of them. The reason behind that, according
to them, is the misconception of the non-rivalrousness of the ideas as a public good.
Although knowledge or ideas seem to be costlessly acquirable at first sight, they argue that
they are not. New ideas are the products of experts and scientists who have spent long years to
acquire necessary skills and knowledge to create new knowledge. In that sense, although ideas
are non-rivalrous, experts and scientists are rivalrous, which means science is expensive to
access. So we should interpret science as an ordinary private good, which is ought to be
supplied at its optimal level via the market forces. Thus, any attempt to intervene in the
economy in order to stimulate science would be useless.
Another criticism on the endogenous growth theory is made by the Parente (2000) on
the basis of theorys applicability on examining economic development. According to him,
the new growth theory falls short on explaining the huge income differences between
countries, while exogenous growth theory does not. For instance, he argues that, if the
technologies and ideas are free; less developed countries do not have to invest in R&D, while
they can import technologies costlessly (like South Korea and China). However, as he says,
endogenous growth models do not explain why all less developed countries do not follow the
same logic. Also, in addition to that, as there is increasing returns on knowledge (reproducible
capital), policy implementations across countries regarding accumulation of intangible capital
(knowledge) determines the different growth rates of per capita income. Thus, there should be
permanent differences between growth rates of different countries as developed countries
carry out successful policies regarding intangible capital accumulation. However, the
empirical evidence shows that there is indeed a catch-up process, which violates the new
growth theorys prediction. South Asian economic miracles and Chinas performance are
examples of that process, as Parente argues.
Having considered all those aspects, we can conclude that the new growth theory has
done a significant and reformist job by endogenizing technological improvements in various
models, which was taken exogenously by neoclassical growth theory. Although we should
admit the new theorys applicability at understanding growth of world knowledge over time; I
think we should be more careful when using it to evaluate economic development before the
new theory is tested and confirmed empirically.

References
Al-Ubaydli, O. & Kealey, T. (2000), Endogenous growth theory: a critique. Institute of
Economic Affairs, Blackwell Publishers.
Arrow, K. J. (1962), The Economic Implicatins of Learning by Doing. The Review of
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Barro, J. R. & Sala-i Martin, X. (2004), Economic Growth, Second Edition, The MIT Press,
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Pack, H. (1994), Endogenous Growth Theory: Intellectual Appeal and Empirical
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