Briefing Paper on endogenous growth theory in connection of forth-coming meeting with CBI and a Treasury team.

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Briefing Paper on endogenous growth theory in connection of forth-coming meeting with CBI and a Treasury team.

Prepared for: Mrs Smith (The Boss)Date:31 Oct 2003

Prepared by: Ann Smith

Endogenous growth theory is an extension from one basic neoclassical growth model, which was first formalised by Robert Solow in 1950's. There are a number of basic assumptions underlying the neoclassical growth model.

The first one is that the productive capacity of the economy can be adequately characterised by a constant return to scale production function with diminishing returns to capital and labour. The second assumption is that firms are price takers in a competitive market place. In other words, no individual firms are assumed to hold no market power. The last assumption is that technological change is entirely exogenous, it is independent of the actions of the consumers and producers and it is available to all countries at no cost.

There are few implications of the neoclassical model of growth. The first major problem is that sustained increases in per capita income can be supported only by sustained increases in total factor productivity. In Solow's model, output per worker can rise only if the ratio of capital per worker increases or total factor productivity increases. Since this model assumes diminishing returns to capital, there is a limit to how much capital accumulation can add to output per capita. Thus, the only way to increase output per worker in the long run is to have sustained productivity growth. This is a major weakness of the neoclassical growth model, since long-run growth is exogenous, it can be determined by an element that is entirely outside of the model.

A key feature of the endogenous growth theory, which was formed by Paul Romer and Robert Lucas in the late 1980's, unlike the neoclassical model, technological change is not assumed to be exogenous. Therefore, this new growth model is trying to explain where the technologically driven productivity growth comes from.

The development of new technologies and their diffusion across firms and nations are critical components of the growth process. Technological change, which affect productivity does not come from nowhere. It is the result of intervention from economic players. Hence, the incentives are crucial for individuals and firms to innovate and create new products, machines, tools and production techniques. Therefore, a firm or a country that is able to adopt new technologies faster is able to grow faster. Moreover, if all these effects are present, the location of Research and Development activity will matter.

Research and Development composes creative work undertaken on a systematic basis in order to increase the stock of knowledge, including knowledge of man, culture and society, and the use of this stock of knowledge to devise new applications. This work may take the form of basic research, applied research or experimental development. Countries or businesses, which invest in Research and Development, experience the largest gains. This is because Research and Development produces technology, a form of knowledge that is used to enhance the productivity of factors of production and economic growth. Therefore, the location and diffusion of technological progress across firms and nations are almost important as technological change itself.

Endogenous growth theory also provides an insight into how government policy or any other institutional factors could raise the long run equilibrium growth rate of output. These factors can include government regulations, tax incentives, provision of basic foundation, for example capital allowances and a range of other measures.

Confederation of British Industry helps to create and sustain the conditions in which the UK can compete and prosper. It has a number of offices around the UK and in Brussels. It represents businesses and their views on all cross-sectoral issues to the government and...
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