An endogenous growth theory is the type of theory developed primarily by economist Paul Romer and his doctoral advisor at the University of Chicago, Robert E. Lucas. It is a response to criticisms of neoclassical models of economic growth that assumed that technological change was exogenously determined, leading to the pessimistic conclusion that government and market policies could do nothing to increase economic growth in the long term. An endogenous growth theory suggests that technological change is a response to economic incentives in the market that can be created and/or affected by government or private sector institutions.
Neoclassical models of growth could not answer some very basic economic questions, particularly about the differences in economic growth and the quality of life between developed and developing countries. If technological change was indeed exogenous and freely available to everyone, then the only way that rich countries should have such dramatically higher standards of living is if poor countries have significantly less capital and a huge rate of return to additional investment. If that were the case, there should be massive flows of capital from rich countries to poor countries and an equalization of standards of living, but in fact, there is not.
In endogenous growth theory, technological change is a function of the production of ideas. New ideas lead to new and better goods as well as better production techniques and higher-quality older goods. Technological change thus can be increased by providing monopoly power through patents and copyrights to speed the pace of innovation.
The second way technological change can be increased is through investment in human capital, which is the sum of all of a nation's human knowledge. Through education, training and other investments in human capital, a country can increase worker productivity and increase economic growth. Endogenous growth theory also predicts that spillovers from investment in value-added products and knowledge will itself be a form of technological progress and lead to increased growth.
There are several policy implications of endogenous growth theory. First and foremost is the conclusion that policy and institutions do matter and can have an effect on growth. Rather than countries having to wait for exogenous technological progress to occur or being limited to short-term increases in growth that result from policy-induced increases in the savings rate, endogenous growth theory suggests that government and private sector policies can have an effect on long-term growth.
A poor country with little human capital cannot become rich simply by acquiring more physical capital, so investment in human knowledge through education and worker training programs is one key to achieving growth. Likewise, government policies that increase the incentive to innovate also can lead to higher rates of growth. These policies might include things such as subsidies for research and development and the strengthening of intellectual property protections.