Neoclassical growth theory, or also known as the Solow growth theory or exogenous growth theory, posits that long term, sustained economic growth is only possible through technological progress and innovation which increases the efficiency of labor. Changes in the saving and/or investment rate only induces short term growth, in which diminishing returns to capital force the economy to return to a steady state level.
However, it does not explains how or why technological progress is determined or created; it is assumed that this technological progress is exogenous; that is, determined by factors outside the consideration of the model. Critics of the Solow growth model say that this is an unrealistic assumption that does not reflect the underlying economic reality. Their answer to the Solow growth model of exogenous technological growth is a model of endogenous growth, in which technological progress is explained and determined by factors within the scope of the model.
More specifically, according to Roberts and Setterfield, endogenous growth theory, in their own words, have 2 major variants, namely:· An endogenous growth theory is one in which the rate of growth is determined by the equilibrium solution of the growth model itself, rather than being imposed upon the model from without (exogenously); or· An endogenous growth theory is one in which technical progress is explicitly modeled, rather than being treated as exogenously given “manna from heaven” 2Attempts to explain the rate of technological progress has created a model of endogenous growth, in which constant returns to capital are the underlying assumption, compared to diminishing returns to capital in the Solow model. 2 This is made possible by the broad assumption that human knowledge and skills are also a form of capital, and once accumulated; they do not exhibit the properties of diminishing returns since more of it does not “crowd out” other primary factors of capital, relative to other traditional forms of capital. 3 In addition, new knowledge begets further knowledge, which *might* have a virtuous cycle effect at best, and reduce knowledge depreciation at worst. Knowledge can also be viewed as a public good which benefits society as a whole. This makes it a more plausible description of long term economic growth.One of the key results of the endogenous growth model is that government policy decisions can permanently raise a country’s growth rate if they lead to more technological progress and innovation, hence making growth endogenous, as its name suggests. This also emphasize the role of private investment in research and development as the central source of technical progress and innovation, since most research and development is driven by a profit motive in order to capture a short term monopoly or patent, under which more profits can be made.
This suggests that the protection of property rights and patents can increase the incentives for private organizations to engage in research and development. Other policies such as reducing the federal deficit to lower interest rates so that investment in capital and technological research will be simulated, as well as making it easier for people to invest in themselves through more education and training by diminishing the cost of student loans and increasing work pay are also strategies that can boost growth under endogenous growth theory. Hence this is the main attraction of endogenous growth theory – that governments could easily find feasible and reasonably traditional policies that could influence the long term growth rate positively, which would be a huge achievement among the various standard goals of economic policy.
However, endogenous growth theory is not without it’s problems. One of the main failing of endogenous growth theory (theories) is their collective failure to explain non-convergence among rich and poor countries over the long term. In other words, it is unable to explain in sufficient detail why some countries are still much richer than others.Endogenous growth theory is also characterized by some limitations, many of which has its roots in its reliance on formal models which fail to capture the significance of the socio-institutional context.
There should not be an obsession with the formal derivation of new general growth equations. However, endogenous growth models can be used to raise questions and possibilities which in turn guide empirical inquiry and analysis, which would be more useful and have more potential.