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Subject ECONOMICS

Paper No and Title 12: Economics of Growth and Development-I

Module No and Title 20: Endogenous Growth; Intellectual capital: Role of

learning, education and research
Module Tag ECO_P12_M20

ECONOMICS Paper 12: Economics of Growth and Development-I

Module 20: Endogenous Growth; Intellectual capital: Role of learning,
education and research
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Endogenous Growth Models: An Overview
4. Romer’s Model
5. Lucas Model
6. Summary

ECONOMICS Paper 12: Economics of Growth and Development-I

Module 20: Endogenous Growth; Intellectual capital: Role of learning,
education and research
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1. Learning Outcomes

After studying this module, you shall be able to

 Know the meaning of endogenous growth

 Learn the weaknesses of neo-classical growth models
 Identify the impact of technological spillovers on the aggregate production
function of the economy.
 Evaluate the role of human capital on economic growth of any economy
 Analyse the limitations of the basic models of endogenous growth

2. Introduction

In majority of the neo-classical growth models, technical change is considered as an

exogenous factor, though it is an important driver to growth. However, Kaldor and Arrow
proposed the idea of technology having some endogenous component as well. Further,
the Solow Model which is largely based on the idea of residual effect of technical change
and that in the long run, the economies move on the stagnant growth path was challenged
on several grounds e.g. its unrealistic result for exogenous technical progress accounting
for more than 70 per cent of output growth; prediction of convergence among poor and
rich economies in the long run; failure to explain widened growth disparities and long run
imbalances in factor productivities etc. These shortcomings lead to the birth of
endogenous growth theory, which has been formally developed since mid-1980s
following the pivotal works by Romer (1986, 1990) and Lucas (1988) and which has
soon become the dominant framework for studying economic growth and development.
One of the main reasons why economists have grown interested in endogenous growth is
because of an empirical puzzle. The neo-classical model predicts that countries with low
per-capita incomes grow faster than those with high income, so that over time per-capita
incomes converge. But a broader set of data indicated that the rich countries may follow
an ever increasing growth path while the poor economies move on at much slower pace
leading to divergence among these economies. It is also found that even the same type of
technology and rate of investment may not lead to similar results across the economies.
This has also been found that even the same level of foreign direct investment may lead
to different results in different economies with different human and physical capital.
ECONOMICS Paper 12: Economics of Growth and Development-I
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Thus, it is important to find some endogenous factors that determine the rate of growth of
the economies.

3. Endogenous Growth Models: An Overview

The endogenous growth models in contrast to the exogenous growth models believe that
the growth of the economy is more influenced by the internal processes and policies,
structure etc. than merely the external factors. Endogenous growth is long-run economic
growth at a rate determined by forces that are internal to the economic system, that
govern the opportunities and incentives to create technological knowledge. In the long
run the rate of economic growth, as measured by the growth rate of output per person,
depends on the growth rate of total factor productivity (TFP), which is determined in turn
by the rate of technological progress. The neoclassical growth theory of Solow (1956)
and Swan (1956) assumed the rate of technological progress to be determined by a
scientific process that is separate from, and independent of, economic forces.
Neoclassical theory thus implies that economists can take the long-run growth rate as
given exogenously from outside the economic system. Endogenous growth theory
challenges this neoclassical view by proposing channels through which the rate of
technological progress, and hence the long-run rate of economic growth, can be
influenced by economic factors. It starts from the observation that technological progress
takes place through innovations, in the form of new products, processes and markets,
many of which are the result of economic activities. The firms may learn from experience
how to produce more efficiently, a higher pace of economic activity can raise the pace of
process innovation by giving firms more production experience. The spread of this
knowledge and consequently, the macroeconomic effects of any technical progress
depend upon the spillover effects that again depend upon the level of human capital in the
society. Here lies the important difference between the endogenous growth theories and
the neo-classical growth theories which take technical progress as exogenous factors. In
this context, we can discuss here, the basic models of endogenous growth given by
Romer and Lucas.

4. Romer’s Model

This model challenges the basic assumption of neo-classical model of growth which
refers to applicability of diminishing returns in the long run. This model states that many
economies have been able to exhibit increasing returns to scale even in the long run. This
ECONOMICS Paper 12: Economics of Growth and Development-I
Module 20: Endogenous Growth; Intellectual capital: Role of learning,
education and research
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long run increase in per capita income has been possible not due to the external factors
but due to the endogenous technical changes. Any change in technology leads to positive
effects on productivity of the factors whose combined effect may lead to increasing
returns. Romer has discussed about the spillover effects of technical change. He states
that a technical change, any innovation, new method of doing things do not remain with
one individual only. He stresses that the physical part of any new technology may be
privately owned but the knowledge part soon becomes a public good. Since, production is
a social phenomenon, any new method used in a production unit soon spreads to another
units as under perfect markets, the factors are perfectly mobile and they carry their
knowledge along with them. A highly productive factor in a production unit not only
himself/herself higher level of productivity but also raises the level of productivity of his
fellow beings in the production unit. Thus any investment in new knowledge, research
and development or human capital may have greater social returns as compared to its
private returns. As a result the national output would be increasing at an increasing rate
and new unit of human capital investment will yield increasing rate of return. In the
simple framework of Romer’s model, we take a single sector Cobb-Douglas type
production function which has inherent assumptions of homogenous sectors and
applicability of constant returns to scale. But in order to include the spillover effects of
technology on aggregate production of the economy, it includes a separate variable of
human capital. Therefore, the production function in Romer’s model can be read as
follows:
Y=A.Kα.L1-α .Kβ
Here, ‘A’ is the efficiency parameter of given level of technology, ‘L’ stands for units of
labour, ‘K’ for units of capital which is presented here both as the physical as well as

human capital. ‘Y’ is the level of output and α and β are the output elasticies of the
respective variables. Above equation cn also be written as
Y=A.Kα+β.L1-α ..................(1)
At any point of time, the change in output would be possible only due to change in
physical as well as human capital and units of labour along with the changes in factor
productivity, therefore,
dy Y K Y L
 .  . ……….(2)
dt K t L t

ECONOMICS Paper 12: Economics of Growth and Development-I

Module 20: Endogenous Growth; Intellectual capital: Role of learning,
education and research
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The value of different components of this equation can be found by differentiating

dy K
equation (1) partially with respect to ‘K’ and ‘L’ and if we further denote as ΔY,
dt t
L
as ΔK and as ΔL, equation (2) takes the following form:
t
Y K L
 (   )  (1   ) ……(3)
Y K L
If both output and capital stock grow at the same and constant rate, then
Y K
  g and since the growth of labour force depends upon the growth of
Y K
L
population which grows at a natural rate determined exogenously,  n , where, ‘n’ is
L
natural growth rate of population, equation (3) can be rewritten as

g  (   ).g  (1   ).n
 .n
or, g n 
1  (   )
here, g-n shows the growth of per capita income. In absence of any spillover effects of
technological change, the constant returns to scale will be applicable and under such
conditions since β=0, this will mean that g-n will also be equal to zero which indicates
that in absence of spillover effects, the economy will not experience any growth in its per
capital income and hence, the constant returns to scale will be applicable. However, in
Romer’s model all the factors viz. capital stock, labour and technology are assumed to be
working together whose productivities mutually influence each other, the value of β will
always be positive. Hence, if β > 0, the growth of per capita income will also be positive,
therefore, g-n > 0. This is possible only due to the spillover effects of the technology
within as well as across production units.
Although, this model has provided an important breakthrough, yet its applicability
to the developing economies is questionable because many of the assumptions of this
model find little validity in the developing economies e.g. the assumption of single sector
economy may be unrealistic for the dual economies of the developing countries.
Moreover, the developing countries largely face the problem of structural rigidities which
are hardly mentioned by Romer. The analysis of these rigidities is very important in the
context of the spillover effects of technology, research and development or any any type
of knowledge across all production sectors of the economy. Due to these structural
bottlenecks many a times the developing economies are found not to be using the full
capacity of their available capital even though they fight with the problem of shortage of
ECONOMICS Paper 12: Economics of Growth and Development-I
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capital. Romer Model is silent about all such factors in the context of developing
economies while these very factors actually lead to slower growth of the per capita
income in these economies even though they are using the same technology as has been
used by the developed economies. Romer’s model is silent about the causes and effects of
all such problems of the developing countries. Actually, the developing economies lack
sufficient incentives to invest in physical as well as human capital. This has a great effect
on supply of savings, capital formation and hence on growth of income. Besides, during
the transition phase developing countries also undergo the process of reallocation of
resources which are not generally efficient ones, particularly during the initial phase of
the transition. This inefficient reallocation of resources at any point of time has medium
as well as long term effects upon the growth of income of the ecomnomy. But all these
factors have been ignored by Romer’s model. Hence, the developing economies find little
guidance from this model.

5. Lucas Model

Lucas’ model of growth emphasises the importance of human capital in the growth the
economy. He states that it is difference in attainments of the human capital that has led to
worldwide economic disparities. Lucas states that the developed countries went through
the process of industrial revolution long time back in the history of these economies. The
incentive to earn more profits has led to invest in creation of knowledge so that the
conditions of normal profits can be converted in to the long run capacity to earn
supernormal profits. However, this process was hardly understood by the developing
economies. This is their misconceptions or overindulgence in the idea of capital stock
being the sole and most important determinant of economic growth that has led to wrong
strategies and hence they were not able to experience the same level of growth as
experienced by the economies which have experienced the epochs of industrial
revolution. These misconceptions or little understanding of the importance of human
capital has led to lower investments in human capital for a long time in these economies.
Consequently, these economies have lagged much behind the developed economies who
are growing at faster rate leading to divergence across the poor and rich economies of the
world. Actually, the physical capital and human capital are not substitute to each other,
they are rather essential complements of each other. Therefore, a greater investment in
human capital also leads to greater productivity of the physical capital. In this framework
Lucas model emphasises that the skilled workers and the new technology are inseparable
from each other. In order to measure the effect of human capital accumulation on income,
we can identify two separate components of total savings in an economy – these savings
ECONOMICS Paper 12: Economics of Growth and Development-I
Module 20: Endogenous Growth; Intellectual capital: Role of learning,
education and research
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can be used for increase in physical capital stock and/or these savings can also be used
for enhancing the level of human capital in the economy which will lead to an increase in
productivity of labour as well as capital in future time period. To further elaborate the
growth model given by Lucas, let us first look at the basic equation of this model. in this
equation output is considered to be the function of physical as well as the human capital
stock.

y  k  h1 ……….…(1)
Here, ‘h’ stands for human capital and ‘k’ for physical capital. As discussed above, part
of the savings are spent in accumulation of physical capital and its part is spent on
accumulation of human capital. These two components of savings can be expressed in the
following manner. Firstly, taking ‘s’ as the part of savings being used for accumulation of
physical capital i.e.
k (t  1)  k (t )  sy (t ) ……………..(2)
Secondly, the proportion of savings spent on accumulation of human capital can be
expressed as
h(t  1)  h(t )  qy (t ) …………….(3)
Thus, sy(t) and qy(t), respectively show the total amount of resources spent on
accumulation of physical and human capital. For self-sustained growth of the economy,
‘y’, ‘k’ and ‘h’ should be growing at the same rate. The rate of economic growth actually
depends upon the growth of investment in physical as well as human capital. Therefore, it
is important to find the ratio of investment in human capital to that of physical capital.
For this, we would have to find the growth of these two types of capital in an economy.
a). Growth of Physical Capital: The growth of physical capital can be derived from
equation (2) by putting the value of y(t) and also dividing both sides by k(t). The resultant
equation can be written as
1−𝛼
𝑘(𝑡 + 1) − 𝑘(𝑡) 𝑠. [𝑘(𝑡)]𝛼 [ℎ(𝑡)]1−𝛼 ℎ(𝑡)
= = 𝑠. [ ]
𝑘(𝑡) 𝑘(𝑡) 𝑘(𝑡)
If we take h(t)/k(t)=r, this equation can be written as
k (t  1)  k (t )
 sr1
k (t )
Similarly, we can also derive the equation for growth of human capital
b). Growth of Human Capital:
h(t  1)  h(t )
 qr 
h(t )

ECONOMICS Paper 12: Economics of Growth and Development-I

Module 20: Endogenous Growth; Intellectual capital: Role of learning,
education and research
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Since, in the long period the growth of human capital as well as the physical capital are
equal, therefore,
q
sr1  qr  or r 
s
This ‘r’ can be used as long term growth rate and since in the long period, the growth of
income, physical capital and human capital are the same, therefore,
y (t  1)  y (t )
 sr1  qr 
y (t )
 s q1
Thus, the long term growth of the economy depends upon the rate of physical capital
formation as well as human capital formation. It is the human capital which compensates
the fall in growth of output due to applicability of diminishing returns on physical capital.
The human capital investment, rather ensures increasing returns by its internal as well as
external positive and output stimulating effects. The internal and external effects of
human capital formation in any economy can be discussed as below.
(i) Internal Effects of Human Capital: According to Lucas, the total time of a
human being, particularly a worker, can be divided in to two components – the time
spent in production and the time spent in accumulation of human capital. If we
denote the proportion of time spent in production as µ(h), then the time spent in
accumulation of human capital will be 1- µ(h). In any economy, the size of the
labour force as well as its productivity per hour significantly influences the level of
output. Therefore, instead of having merely the size of the work force, Lucas has put
forth the idea of ‘effective labour force’ which is shown as the product of size of the
labour force and the time spent on producing goods and services for a given level of
human capital.

Ne    (h).N (h).dh
0

Here, N(h) is the size of labour force and Ne is the effective labour force. Thus, we
can express production as function of physical capital stock and effective labour
force.
Y=f(K, Ne)
The level of human capital would not only have a macro economic impact upon the
aggregate output of the economy but will also have accrue certain private benefits to
the holders of the human capital as in a competitive market economy, wages are paid
according to the marginal product of workers. Since, the workers with higher level of
ECONOMICS Paper 12: Economics of Growth and Development-I
Module 20: Endogenous Growth; Intellectual capital: Role of learning,
education and research
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human capital are more productive, they would have higher earnings. Total wages in
an economy for a given level of human capital can be calculated as follows:
Total wages = f ' ( K , Ne ).h. (h)
Where, f ' ( K , Ne ) shows the marginal productivity of labour.
(ii) External Effects of Human Capital: Increase in level of human capital formation
in any economy, undoubtedly increase the level of productivity of a single worker
but also have an overall effect upon the average productivity of the economy as a
whole. Even a single worker with higher human capital in a production unit has
huge ripple effects in the production unit. Same is true for the economy as a whole.
But in a perfectly competitive economy, it is generally assumed that human capital
of an individual would not affect the average level of human capital, yet its
opposite is not true as average level of human capital in any economy determines
the minimum target to be achieved by average workers to ensure their
employability. Hence human capital investments and its attainments by the private
individuals are largely determined by the average level of human capital for the
country as a whole. This is termed as external effect of human capital. In order to
know about the external effect of human capital, it is important to know about the
average level of human capital which can be calculated as below.

 h.N (h).dh
ha  0


 N (h).dh
0

Here, ha is average level of human capital in a country. Now, we can easily adjust
our production function by incorporating internal as well as external effect of
human capital. First of all let us have production as function of capital and effective
labour force.
Q  A.K  (t ) Ne1 (t )
Putting the value of Ne, we get
Q  A.K  (t )[  (t ).h(t ).N (t )]1 
Incorporating the external effects of human capital or the average level of human
capital for the society as a whole
Q  A.K  (t )[ (t ).h(t ).N (t )]1 [ha (t )]
Any increase in time for accumulation of human capital i.e. 1-  (t ) will raise the
individual as well as the average level of human capital of the society which will

ECONOMICS Paper 12: Economics of Growth and Development-I

Module 20: Endogenous Growth; Intellectual capital: Role of learning,
education and research
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have positive effects upon the level of output at an increasing rate. Thus, the
economy would grow at a faster rate due to applicability of increasing returns to
scale in the production sector. The change in human capital, which is the main force
behind the faster growth of the economy, can be measured as
hˆ(t )  [h (t )] .G[1   (t )] ,
a

here, G is the growth of human capital and it is always positive i.e. G > 0 but the
existing level of human capital or say the knowledge, which the society has attained
so far, will have diminishing returns to output, therefore,  < 0. In order to simplify
the analysis if we simply assume  =1, then the equation showing the change in
human capital at any point of time can be shown as
hˆ(t )  [h (t )].G[1   (t )]
a

We can discuss here two extreme cases, one is when whole of the time is spent in
accumulation of human capital i.e.  (t ) = 0, and the second when whole of the time
is spent in production only i.e. 1-  (t ) = 0 . In the first case, the change in human
capital will be
hˆ(t )
G
[h(t )]
i.e. the economy can achieve the highest growth of human capital equal to G while
in second case there will be no change in growth of human capital and it would be
zero. In absence of any change in human capital, since diminishing returns to scale
are applicable to the existing level of human capital, the economy will also grow at
diminishing rate for any change in its inputs. But in real life, the value of  (t ) or
that of 1-  (t ) varies between 0 and 1 which shows that the economy moves on a
continuous growth path and the rate of growth of the economy will be higher for
higher growth of human capital. This fact points towards the fact that the
applicability of diminishing returns can be postponed by increasing investment in
human capital. Thus, the economies with higher rate of growth of human capital
experience a higher growth of income and the economies with lower investment in
human capital will experience the lower growth of income, leading to divergence
between the two types of the countries. Through this fact, Lucas pointed out that the
the gap between growth of rich and poor economies can be explained by the gap in
investments in human capital in these economies.
Finally, Lucas also differentiated between the optimum growth path and the
equilibrium growth path. By optimal path he means that the society wants to
maximise its utility function by achieving the optimal level of per capita income
ECONOMICS Paper 12: Economics of Growth and Development-I
Module 20: Endogenous Growth; Intellectual capital: Role of learning,
education and research
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with an optimal combination of K(t), N(t), c(t), h(t) and ha(t). On the other hand,
equilibrium path means that there is simultaneous equilibrium in all firms and
households as well the economy as a whole. Assuming that ha(t) is exogenously
determined and it is expected that each individual will follow the same path so that
the actual behaviour coincides with the expected behaviour and there is no gap
between demand and supply (i.e. AD = AS), for given physical and human capital
stock. The solution will be achieved in both the cases if h(t) = ha(t). Any divergence
between the two will mean the divergence from the equilibrium as well as the
optimal growth path.

Like Romer’s Model, Lucas’ Model also gave little attention to the structural rigidities of
the developing economies. There is no doubt that these economies have low level of
productivity due to low level of human capital but at the same time these economies are
also suffering from the problem of misallocation and misutilisation of the available
resources. These economies not only face the problem of skilled workers but also
underutilisation of existing human capital. Due to lack of opportunities and low returns to
human capital, there is little incentive to invest in human capital by private individuals.
On the other hand, the skilled workers have a greater tendency to migrate to other
countries in search of better opportunities. These are the workers which the economy
needs the most and their emigrations means the drain of most essential and productive
resources. This loss of intellectual capital has a huge and long run adverse effect upon the
economic growth of the poor countries. These aspects are ignored by Lucas’ model of
endogenous growth, yet there is no doubt that the developing economies can learn a lot
from this model that it is the higher level of human capital that can ensure higher
productivity of other resources. So, it must be attained as well as retained.

ECONOMICS Paper 12: Economics of Growth and Development-I

Module 20: Endogenous Growth; Intellectual capital: Role of learning,
education and research
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6. Summary

The neo-classical growth theories, though recognised the importance of technology but
they took it as exogenous factor and therefore they failed to explain why even in the long
run the richer economies are growing at a rate higher than the poor economies and why
same level of investment and technology do not produce similar results across the
economies. Moreover, there is little evidence of convergence between the two types of
the economies as suggested by Solow’s framework. The answers to many of these
questions can be found in the endogenous growth models which state that the returns to
capital and a given technology mainly depend upon the inherent characteristics of the
economy and therefore, the factors to growth are endogenous rather than being
exogenous. This is the spillover effect of the technology and the spread of human capital
that leads to increasing returns to scale even in the long run. Higher is the speed of these
spillovers, higher will be the rate of growth of the economy. Similarly, the economies
which invest more in human capital are also able to grow at a higher rate than the
economies which spend less on the same. Yet, these models have proposed one sector
economy which finds little applicability in the developing economies which are dual in
character and face the problem of structural rigidities. In the developing economies,
misallocation of the resources is as big an issue as the availability of the same. Though
the endogenous growth models are the important breakthrough in the existing knowledge
of growth economics but they hardly deal with the important issues of the developing
economies which hinder the process of growth even with increase in investment in
human capital as well as creation of technology.

ECONOMICS Paper 12: Economics of Growth and Development-I

Module 20: Endogenous Growth; Intellectual capital: Role of learning,
education and research