Exogenous Growth Theory
Exogenous Growth Theory assumes that a production function relates output to capital and labor inputs.
What Is The Exogenous Growth Theory?
Exogenous growth theory highlights the role of external factors such as technological progress, population growth, savings rate, and government policies in driving predictable effects on economic growth.
Assuming that the economy is unaffected by internal factors, the theory suggests that external factors cause predictable effects.
According to the theory of exogenous growth, a country's technology increase leads to faster economic growth due to boosted productivity and efficiency.
If there is a higher savings rate in a country, then the economy will grow faster because savings provide more funds for investment and capital accumulation. A country's economy will grow faster if economic activity and innovation are encouraged.
For instance, low taxes or free trade due to favorable government policy in a country will promote this growth. Certain principles of neoclassical economics serve as the foundation for exogenous growth theory.
These assumptions include perfect competition, constant returns to scale, diminishing marginal returns to capital, and exogenous technological change.
Key Takeaways
- Exogenous growth theory assumes that a production function relates output to capital and labor inputs.
- Variables in exogenous growth theory, such as the savings rate, are determined outside the model by preferences or institutions.
- In this theory, the economy also grows by benefiting from technological progress, which is not affected by the economic variables in the model.
- Exogenous growth theory ignores human capital, innovation, institutions, and other factors that may affect economic growth.
Understanding Exogenous Growth
The most famous model of exogenous growth theory is the Solow-Swan model, which Robert Solow and Trevor Swan developed. The Solow-Swan model shows how an economy's output (GDP) depends on its inputs (factors of production), such as labor and capital.
The model illustrates that an economy's output increases over time due to external factors like technological advancements and a larger population.
The model predicts that an economy will eventually reach a steady state where output per capita stops growing because of diminishing returns to capital. At this point, only technological progress can increase output per capita further.
Over time, some countries tend to grow faster than others, which exogenous growth theory helps explain. Additionally, this theory helps to account for why growth rates tend to converge. However, it also has some limitations and criticisms.
Economists argue that endogenous factors that exogenous growth theory overlook include human capital, innovation, institutions, culture, and entrepreneurship.
These factors are not independent of what happens inside the economy but rather depend on and influence each other.
They also argue that exogenous growth theory does not account for increasing returns to scale, externalities, market failures, or technological spillovers that can affect economic growth.
Exogenous vs. Endogenous Growth
An economy's internal factors—including its institutions, policies, innovation, technology, and human capital—pave the way for endogenous growth, a type of economic growth.
| Exogenous Growth | Endogenous Growth |
|---|---|
| Growth is driven by outside factors | Internal factors fuel economic growth |
| Believes in a limit to growth | Argues economies can grow indefinitely |
| Growth is variable | Growth is sustainable |
Creating a proficient workforce, stable business environment and efficient transportation networks can generate endogenous growth in countries that invest in education, good governance, research and development, and infrastructure.
Generating new technologies and being proactive in investment in the former also plays a role in promoting this positive development.
An economy's growth that relies on factors outside of it, like trade, population increase, foreign aid, and natural resources, is referred to as exogenous growth.
Exogenous growth theory suggests that economies have a natural limit to their growth potential.
For example, a country that relies on oil exports, imports of capital goods, foreign loans, and immigration can generate exogenous growth by exploiting its natural resource endowment, accessing global markets, borrowing funds, and increasing its labor supply.
Endogenous growth comes from within the economy and is driven by its capabilities and innovations.
Exogenous growth comes from outside the economy and is driven by its interactions with other economies and agents. Another difference is the sustainability of growth.
Endogenous growth can be sustained indefinitely as long as the economy continues to invest in its internal factors and improve its productivity.
It's a toss-up with exogenous growth—it can either be brief or unpredictable, swayed by elements that are out of the economy's command and may alter throughout time. To sum up, endogenous and exogenous growth are two ways of explaining how economies grow over time.
They differ in their source and sustainability of growth. Endogenous growth relies on internal factors and can be indefinite. Exogenous growth relies on external factors and can be limited or volatile.
Both types of growth have advantages and disadvantages depending on the context and situation of each economy.
What is the Solow Growth Model of Exogenous Growth?
Over time, how an economy expands can be deciphered through the Solow growth model, which revolves around the crucial elements of capital, labor, and technology.
Capital is the stuff that helps produce more stuff, like machines, buildings, and tools. Labor is the people who work with the capital to produce things, like workers, managers, and entrepreneurs.
Technology is the knowledge and skills that make production more efficient and innovative, like inventions, discoveries, and education.
The Solow growth model assumes that these three factors are combined in a certain way to produce output, which is the total amount of stuff that an economy produces.
The model also assumes that some of the output is saved and invested in more capital while some are consumed. The assumption is made that labor grows due to population increase at a constant rate and that innovation causes technology to improve at a constant rate.
The main question that the Solow growth model tries to answer is: how does an economy grow over time? According to the model, an economy's growth potential can be boosted in two ways, by increasing technology per worker or capital per worker.
To use, each worker has a certain amount of capital available. Technology per worker is the level of technology available for each worker to use.
Per worker, the output of capital per worker has a limit that is demonstrated in the model. As capital per worker is augmented, per-worker output improves. Output diminishes as capital is increased due to the law of diminishing returns.
The more capital invested, the less output increase will be experienced per unit of capital invested. Eventually, the economy reaches a steady state where output per worker stops growing and only keeps up with population growth and technology improvement.
Economic Growth in the Solow Model
The model also shows that increasing technology per worker leads to higher output per worker without any limit. This is because of increasing returns: as more and more technology is added, each additional technology unit adds more and more to output.
The key to keeping an economy growing endlessly is by boosting its technological advancements. The Solow growth model has many implications for economic policy and development.
As per this model, simply saving and investing more may not be the key to attaining long-term economic growth. This strategy can still yield short-term benefits, as evidenced.
According to this model, promoting technological progress can have positive economic impacts in both the long and short term. This implies that technological improvements could lead to a rise in economic growth. This hints at a correlation between the two.
Note
Similar levels of technology and population growth indicate a possibility for financially challenged nations to reach the success of wealthier nations.
The Solow growth model is not perfect, of course. It makes many simplifying assumptions that may not reflect reality. The quality and quantity of workers' education and skills—what is known as human capital—is a critical component that is often overlooked.
Rules and norms that govern economic activity are known as institutions, but they are often disregarded in economic analyses. It also ignores the role of natural resources, which are the inputs from nature that are used in production.
These factors may also affect economic growth in important ways. Nevertheless, the Solow growth model is a useful tool for understanding the basics of economic growth. It helps us see how different factors affect output per worker over time.
It also helps us compare different economies and their growth potential.
Example of Exogenous Growth
An economic theory called exogenous growth theory is what neoclassical economics subscribes to. It posits that external factors, the ones outside an economy, industry, or individual business, hold greater sway over success than internal factors.
In other words, endogenous factors inside the organizational structure aren't as important as those occurring outside it.
Government policies, technological advancements, population growth, and independent economic systems are the primary driving forces of economic prosperity, as suggested by this theory.
Essentially, this theory indicates that economic growth is determined by factors that stand outside of the economy itself.
This theory contrasts with endogenous growth theory, which argues that economic growth is driven by internal factors such as human capital, innovation, and knowledge spillovers influenced by the economic system.
Endogenous growth theory suggests that economic agents can create an environment that fosters technological progress and sustained growth. So how can we apply exogenous growth theory in an example?
Let's take two nations into account: Country A and Country B, for a comparison. Despite having comparable levels of capital and labor, Country B needs to catch up with Country A regarding technological advancement.
This implies that Country A has been making more significant strides in upgrading its technology than Country B.
According to exogenous growth theory, Country A will have a higher economic growth rate than Country B because technological progress is an external factor that increases productivity and output.
Country A, being ahead of Country B, doesn't necessarily imply that Country B is permanently lagging; there's still hope for them to level up.
Suppose Country B adopts policies that encourage:
- Savings
- Investment
- Education
- Research and development
- Trade
Due to this, it can also increase its rate of technological progress and achieve higher economic growth.
According to exogenous growth theory, these policies are also external factors that affect economic growth. Of course, this theory is not without its limitations and criticisms.
Some economists argue that it ignores the role of endogenous factors such as human capital, innovation, and knowledge spillovers that can also generate economic growth.
Moreover, exogenous growth theory does not explain how technological progress is created or diffused in the first place. In reality, it may not be true that there are diminishing returns to capital and labor, which is also assumed.
Strengths and Weaknesses of the Exogenous Growth Theory
Modeling economic growth through exogenous factors is the central idea behind the exogenous growth theory. This theory considers various external factors like population, technology, and natural resources and their influence on growth.
It assumes that these factors are given and do not change over time. Adding more capital to the economy leads to less output per unit of capital, according to the theory, which also assumes there are diminishing returns.
The exogenous growth theory has some strengths and weaknesses. Based on external factors, it can explain why some countries grow faster than others in the long run; this is one of its strongest suits.
Technological innovation plays an important role in driving economic growth, making it a valuable strength. Modern economies highly regard their ability to capture this aspect.
However, the exogenous growth theory also has some limitations. One weakness is that it does not explain how the economy determines or influences external factors.
For example, it does not account for how human capital, institutions, policies, or culture can affect technological progress or population growth. It fails to consider the adverse effects on the environment when economic progress is made.
Case in point, it does not consider the consequences of pollution, depletion of resources, and climate change. These impacts can affect the sustainability and quality of growth in the long run.
As shown, the exogenous growth theory is a useful but incomplete framework for understanding economic growth.
External factors can aid our comprehension of growth, yet they offer no insight into how these factors are intertwined with the economy or if they originate from within.
Note
It also ignores the environmental costs and benefits of growth, which are crucial for evaluating the welfare of society.
Exogenous growth is only one economic growth perspective. To learn more about this topic, you should also explore endogenous growth models.
Summary
Endogenous growth theory is an alternative theory that tries to address the issues of exogenous growth models by incorporating endogenous factors into the analysis of economic growth.
Endogenous growth theory suggests that economic growth is driven by forces within the economy itself.
These forces include learning by doing, research and development, knowledge creation and diffusion, and human capital accumulation. Endogenous growth theory also suggests that economic growth can be sustained indefinitely without reaching a steady state.
This is because of increasing returns to scale and positive feedback loops. One well-known example of an exogenous growth theory is the Solow Growth Model.
This model attempts to model economic growth by using a production function. It takes labor, capital, and technology inputs and outputs GDP.
Although this form of growth model can explain a significant portion of economic growth, it is not a perfect model. It cannot explain endogenous growth within economies, for example. In addition, it does not show how institutions within the economy impact its growth.
For example, pollution is produced by an economy. However, it is ignored in exogenous growth models even though it can significantly impact overall economic growth and well-being.
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