- John Barrdear - http://john.barrdear.com -

Endogenous Growth Theory

Following on from yesterday [1], I thought I’d give a one-paragraph summary of how economics tends to think about long-term, or steady-state, growth.  I say long-term because the Solow growth model [2] does a remarkable job of explaining medium-term growth through the accumulation of factor inputs like capital.  Just ask Alwyn Young [3].

In the long run, economic growth is about innovation.  Think of ideas as intermediate goods. All intermediate goods get combined to produce the final good. Innovation can be the invention of a new intermediate good or the improvement in the quality of an existing one. Profits to the innovator come from a monopoly in producing their intermediate good. The monopoly might be permanent, for a fixed and known period or for a stochastic period of time. Intellectual property laws are assumed to be costless and perfect in their enforcement. The cost of innovation is a function of the number of existing intermediate goods (i.e. the number of existing ideas). Dynamic equilibrium comes when the expected present discounted value of holding the monopoly equals the cost of innovation: if the E[PDV] is higher than the cost of innovation, money flows into innovation and visa versa. Continual steady-state growth ensues.

It’s by no means a perfect story.  Here are four of my currently favourite short-comings:

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[…] much smarter than I am was kind enough to read my little post on Endogenous Growth Theory.  At lunch today, they drew attention to this item that I mentioned: I’m not aware of anything […]