How does endogenous growth analysis differ fundamentally from Solow’s economic

growth model?

Answer 1.a]

Introduction – Two models of growth

The wide disparity in the economic output of people in different countries had led
economists to study economic growth and understand what made some countries
rich and some poor. Economists have wondered if it was possible to replicate the
growth and living standards achieved by the developed countries with equal
success in the poor countries of the world. They have also pondered on how the
growth in the developed nations could be sustained or whether in the long run
there was the danger of these nations slipping into relative poverty after a peak in
growth rates.

It was evident to the neoclassical growth economists that the rapid economic
growth experienced by USA, and to a lesser extent, Europe could not be attributed
solely to the increases in capital employed. This is because the accumulation of
capital by an economy is bound to exhibit diminishing marginal returns after a
while and not result in prolonged periods of growth as has been observed. For
instance, a ‘well-behaved’ Cobb-Douglas Production function yields constant
returns to scale but diminishing marginal returns as more of an input is added:

Y = (Kα,L1-α )

Where α < 1

To explain the economic growth of America and Europe from the middle of the
nineteenth century through the twentieth century, growth economists added
another factor in the production function, namely, technology. There are two main
theories of economic growth incorporating the effects of technical knowledge - the
exogenous growth theory and the endogenous growth theory. The essential
difference between these two models arises from the way each explains the nature
of Technology and consequently the varying effect it has on economic growth.

Solow Growth Model

The exogenous model or the Solow-Swan theory of economic growth is an

extension of the Harrod-Domar model of growth, incorporating technology. Solow
assumes technological knowledge as coming from research and innovations
happening around the world. This knowledge is not the outcome of activity in an
economy and it impacts the efficiency of labour. As technology is a ‘given’, it is
exogenous to the model. Solow assumed that all economies had access to the same
pool of knowledge, so accumulation of capital was crucial and central to a
country’s growth rate. That part of growth which could not be explained by capital
and labour increases was ‘the residual’ that accrued from technology change. The
role of technology as a labour augmenting factor in Solow’s model is presented
below:

Y = (Kα,AL1-α )

‘A’, is exogenous technological knowledge, improving productivity of labour.

Because technological change is assumed to be outside the economy, the Solow

growth model exhibits constant returns to scale and diminishing marginal returns
to capital.

In Solow’s model, savings, population growth and technological progress affect

growth but they are all exogenous. An increase in the savings rate in the Solow
model results in a short term increase in growth during the transitional period,
however, because of the diminishing returns to capital, the per capita growth in
the economy occurs only until the capital stock reaches a steady state. Once that
state is achieved, there is equilibrium and intensive growth becomes zero. To
experience per capita growth again, either an exogenous technological change
needs to occur or savings rate needs to increase or population growth rate should
fall. But the effect of all these factors on growth is only transitory.

Endogenous Growth Model

However, some later growth economists - Frankel, Romer [1986] and Lucas [1988]-
found it difficult to accept that the rapid improvements in technology that were
witnessed in the twentieth century, as emanating solely from outside economic
activity. This was because any activity, including innovation and technical
improvement, is pursued continuously only if people are rewarded for it. It was
unlikely that a production process would be continuously bettered by people who
will not reap the benefits for their efforts – which would be the case if the
innovators were outside the economy. So the producers of goods were more
motivated to introduce new products or find ways to improve their productivity to
increase profitability. Therefore the new growth economists were of the view that
technological change was generated by the day to day economic activity and so
endogenous, to the model of growth. The basic version of an endogenous growth
model, the AK model, used the term ‘Technology’ to include both technological
change and human capital.

According to the endogenous growth theory, a firm that accumulates physical

capital to produce goods will also gather knowledge specific to that production
process. Since, the technological knowledge came from ‘learning by doing’ through
economic activity, it follows that capital was initiating this technological change
and it was capital that was being worked upon to make it better. Thus
technological knowledge was itself a kind of capital as it was changing the
productivity of capital. And unlike physical capital, knowledge capital does not
suffer from diminishing marginal returns, on the contrary knowledge is an
invaluable input having the unique quality of providing increasing returns owing to
its spill-over effects. Knowledge once created can be reused with zero cost and
almost no depreciation as old knowledge builds new knowledge. So the new
growth economists introduced technology to impact capital instead of labour as
Solow had presented in his model. By assuming that technology augmented capital,
the new growth economists changed the productivity of capital from one of
diminishing marginal returns in the Solow model to one of either constant or even
increasing marginal returns on capital.

The simplest form of the endogenous growth model with technology augmenting
Capital is:

Y =f(AKα,L1-α )

A is a constant that is >0 and represents technological change and if α = 1 then,

Y= AK

In the AK model, one unit of capital is enhanced ‘A’ number of times because of
technological change. Now if savings is a fixed portion of Output then:

S = sY = sAK

Investment is equal to Net Investment plus depreciation, ∂:

I = ∆K + ∂

Since savings is equal to investments, then

sAK = ∆K + ∂

and dividing both sides by K, change in capital or aggregate net investment is:

∆K = sA- ∂

Since Output, Y, is proportional to capital, K, the growth in capital will result in a

proportional increase in output:

∆K = ∆Y = sA - ∂

Therefore, Growth is equal to sA- ∂.

There is no steady state in an endogenous growth model, which means an increase

in savings rate will result in a permanent long run increase in output per capita
unlike in the Solow growth model where an increase in savings rate has only a short
term impact on increasing the growth rate.

Conclusion
The endogenous growth model lays great importance on an economic system
investing in research and development as that will help increase the living
standards of people. The endogenous growth economists therefore see a role for
governments in propelling growth in their countries by encouraging innovation and
research, raising the savings rate, investing in infrastructure, building institutions,
improving the quality of human capital through education and training and
facilitating international trade among other things. Since the exogenous growth
economists treat technology as a factor outside economic activity, government
policies help in driving transitional growth towards the new steady state but have
little impact on the long run growth.

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