Endogenous growth theory
Based on Wikipedia: Endogenous growth theory
The Economic Heresy That Changed How We Think About Growth
Here's a question that haunted economists for decades: Why do some countries stay rich while others stay poor? And more puzzlingly, why doesn't the gap ever seem to close the way their models predicted it should?
For most of the twentieth century, economists had a tidy answer. Growth, they said, came from outside the economic system—from technology that appeared like manna from heaven, from savings rates that were simply given, from forces beyond anyone's control. The economy was like a car rolling downhill: you could steer a little, but gravity (or in this case, "exogenous factors") determined your speed.
Then, in the mid-1980s, a group of rebellious theorists looked at this explanation and called it what it was: a cop-out.
The Problem With Treating Growth as a Mystery
The dominant growth model of the era was the Solow-Swan model, named after economist Robert Solow, who would win a Nobel Prize for it. The model was elegant. It was mathematically rigorous. And it had one glaring problem.
It couldn't actually explain where growth came from.
In the Solow model, long-run economic growth depends on "technological progress"—but the model treats this progress as a given, an input from outside the system. It's as if you built a model of how cars work, and when asked what makes them go, you answered: "Movement. Movement makes them go." Technically true, but not exactly illuminating.
This bothered a lot of economists. If technology drives growth, and we can't explain technology, then we can't explain growth. We're just describing it, not understanding it.
Enter Paul Romer.
Ideas Are Different From Things
Romer, who would eventually win his own Nobel Prize in 2018, proposed something radical. What if the engine of growth isn't outside the economic system at all? What if it's inside—endogenous, to use the technical term—and what if we can actually model it?
The key insight was about the nature of ideas.
Physical goods are what economists call "rival." If I'm using a hammer, you can't use it at the same time. We have to take turns, or buy separate hammers. This rivalry creates scarcity, which creates diminishing returns: the more hammers a carpenter has, the less valuable each additional hammer becomes.
But ideas don't work that way.
If I know how to make a better hammer, and I teach you, I still know it too. Ideas are "non-rival." They can be used by everyone simultaneously without being used up. And this changes everything about how we should think about growth.
The Spillover Effect
Think about what happens when a company invests in research and development. They might discover a new technique for manufacturing semiconductors. That technique helps their business, certainly. But knowledge has a funny way of leaking out.
Engineers leave for other companies. Papers get published at conferences. Competitors reverse-engineer products. Suppliers learn new methods. Gradually, the knowledge spreads through the entire economy.
Economists call these "positive externalities" or "spillover effects." The company that invested in the research captures some of the benefits, but society captures many more. The rising tide lifts all boats, even the ones that didn't pay for the tide.
This spillover effect is the beating heart of endogenous growth theory. It explains why investing in knowledge and human capital doesn't face the same diminishing returns as investing in physical capital. Each new idea makes the next idea easier to discover. Progress feeds on itself.
The AK Model: Simplicity Itself
The simplest version of endogenous growth theory is called the AK model, and its elegance is almost suspicious.
Traditional growth models assume that adding more capital to an economy eventually yields smaller and smaller returns. Double your factories, and you won't quite double your output. Triple them, and you'll get even less bang for your buck. Economists call this "diminishing returns to capital," and it's why the Solow model predicts that poor countries should grow faster than rich ones—they have more room to add capital before running into diminishing returns.
The AK model makes one simple change: it assumes these diminishing returns don't happen, at least not at the level of the whole economy. The reason? Spillovers. When companies invest in capital, they generate knowledge that benefits everyone, offsetting the diminishing returns that would otherwise occur.
In mathematical terms, if you plot output (Y) against capital (K), you don't get a curve that flattens out. You get a straight line. Output equals A times K, where A represents the overall productivity of the economy. Hence: AK.
This simple change has profound implications. If there are no diminishing returns, then countries don't automatically converge toward the same standard of living. Rich countries can stay rich. Poor countries can stay poor. And crucially, policy choices about investment in knowledge and human capital can permanently affect how fast an economy grows.
Why Education Might Matter More Than Factories
One of the most influential extensions of endogenous growth theory came from Robert Lucas, another Nobel laureate, in 1988. Lucas focused specifically on human capital—the skills, knowledge, and capabilities that workers accumulate through education and experience.
In Lucas's model, when workers become more skilled, they don't just become more productive themselves. They make everyone around them more productive too. A city full of educated workers generates more innovations, more efficient processes, more creative solutions than a city of uneducated workers, even if both cities have the same number of people and the same amount of physical capital.
This helps explain some puzzling facts about the real world. Why do companies cluster in expensive cities when they could save money by locating elsewhere? Why do some regions become innovation hubs while others languish? The spillover effects of human capital create a kind of gravitational pull—skilled workers attract more skilled workers, and the resulting interactions generate growth that benefits everyone nearby.
It also suggests that government policy matters enormously. Subsidies for education, support for basic research, investments in universities—these aren't just nice things to have. They're potentially engines of permanent growth acceleration.
The Role of Monopoly and Patents
Here's where endogenous growth theory gets interesting, and perhaps a bit uncomfortable for free-market purists.
If ideas are non-rival—if they can be used by everyone simultaneously—then in a perfectly competitive market, no one would invest in creating them. Why spend millions on research if your competitors can immediately copy your discoveries? The private incentive to innovate would collapse.
This is where patents and intellectual property come in. By granting temporary monopoly rights to inventors, the patent system creates an artificial scarcity around ideas. Yes, the idea could be used by everyone. But legally, only the patent holder can use it for a set number of years.
In many endogenous growth models, this temporary monopoly power is essential. Research and development firms invest heavily in creating new ideas, knowing they'll be able to profit from them for a while. These profits fund more research, which creates more ideas, which funds still more research.
But there's a tension here. Monopoly power, even temporary monopoly power, is inefficient. While a patent is in force, the idea isn't spreading as widely as it could. Society pays a price for the innovation incentive.
Getting this balance right—enough intellectual property protection to incentivize innovation, but not so much that it stifles the spread of ideas—turns out to be one of the most important and difficult questions in economic policy.
The Policy Implications Are Revolutionary
Traditional growth theory offered governments a somewhat passive role. You could tinker with savings rates, maybe. You could try not to mess things up too badly. But ultimately, technological progress would happen on its own schedule, and there wasn't much you could do about it.
Endogenous growth theory tells a completely different story.
If growth comes from innovation, and innovation comes from investments in knowledge and human capital, and those investments respond to incentives, then government policy can permanently change an economy's growth trajectory. Not just the level of output, but the rate at which output increases, year after year, forever.
The economist Peter Howitt put it memorably:
Sustained economic growth is everywhere and always a process of continual transformation. The sort of economic progress that has been enjoyed by the richest nations since the Industrial Revolution would not have been possible if people had not undergone wrenching changes. Economies that cease to transform themselves are destined to fall off the path of economic growth. The countries that most deserve the title of "developing" are not the poorest countries of the world, but the richest. They need to engage in the never-ending process of economic development if they are to enjoy continued prosperity.
This is a striking claim. Even the wealthiest nations aren't "developed" in the sense of being finished. They're works in progress, and the moment they stop changing, stop innovating, stop transforming, they begin to decline.
The Critics Have a Point
Endogenous growth theory is influential, but it's not universally accepted. Several criticisms have stuck.
First, there's the convergence problem. Traditional growth theory predicts that poor countries should grow faster than rich ones and eventually catch up—a process called "convergence." The empirical evidence actually supports this prediction, at least for countries with similar institutions and policies. But simple endogenous growth models don't predict convergence at all. If there are no diminishing returns, why would poor countries ever catch up?
More sophisticated endogenous models can be tweaked to generate convergence, but critics argue this is ad hoc—adding complexity to match the data rather than deriving predictions from first principles.
Second, there's the measurement problem. The Nobel laureate Paul Krugman, never one to mince words, criticized endogenous growth theory as "nearly impossible to check by empirical evidence." The theory talks about how unmeasurable things (like the stock of knowledge) affect other unmeasurable things (like the rate of innovation). If you can't measure the key variables, how can you test whether the theory is right?
Third, there's the development puzzle. Despite its complexity and sophistication, endogenous growth theory hasn't proven notably better than simpler theories at explaining why some countries develop and others don't. The economist Stephen Parente has argued that the new theory, for all its mathematical elegance, doesn't actually add much explanatory power over the old models it was supposed to replace.
What Endogenous Growth Theory Gets Right
Despite these criticisms, endogenous growth theory has fundamentally changed how economists and policymakers think about growth. Several insights seem likely to endure.
Ideas matter. This sounds obvious, but it wasn't always part of economic models. The recognition that knowledge is fundamentally different from physical goods—non-rival, potentially infinite in supply, subject to increasing rather than diminishing returns—is a genuine contribution to economic thinking.
Institutions matter. If growth depends on innovation, and innovation depends on incentives, then the institutions that shape those incentives—patent law, education systems, research funding, market competition—are central to economic success. This helps explain why some countries with abundant natural resources stay poor while others with almost no natural resources become wealthy.
Policy choices have long-run consequences. In the old models, bad policy might make you poorer, but once you fixed the policy, you'd eventually return to your previous growth path. In endogenous growth models, bad policy can put you on a permanently lower trajectory. Every year of underinvestment in education or innovation is a year of compounding losses that can never be recovered.
The Deeper Lesson
Perhaps the most profound implication of endogenous growth theory is philosophical rather than economic.
For most of human history, economic growth was essentially zero. Generation after generation lived at roughly the same standard of living as their parents and grandparents. Then, starting around 1800, something changed. Growth began, slowly at first, then accelerating. Living standards in the richest countries are now perhaps a hundred times higher than they were two centuries ago.
What changed?
Endogenous growth theory suggests an answer: we learned how to generate and spread ideas systematically. We built institutions—universities, research laboratories, patent offices, competitive markets—that incentivized innovation and allowed knowledge to spill over throughout the economy. We created a system that feeds on itself, where each new idea makes the next one easier.
This process isn't automatic. It requires constant cultivation. It requires policies that embrace change rather than protecting the status quo. It requires accepting the "wrenching changes" that Howitt described—the creative destruction where old industries die so new ones can be born.
The countries that understand this, that build their institutions around it, that accept the discomfort of constant transformation—these are the countries that will thrive. The ones that try to freeze their economies in place, to protect existing industries and firms from competition and change, will slowly fall behind.
Growth, in this view, isn't something that happens to us. It's something we choose, through the institutions we build and the policies we pursue. And that choice, made fresh each generation, determines whether our children will be richer or poorer than we are.
The math may be complicated. But the lesson is simple: invest in ideas, invest in people, embrace change, and growth will follow. Stop doing these things, and it won't.