7) Endogenous Growth The Solow growth model we studied in the last section took all the parameters as exogenous.

That is, we have no way of knowing how they are determined in the model. We also saw that total factor productivity was responsible for sustained growth but that each level of TFP led to a steady state where growth stopped.. The endogenous model explains why growth can continue through time. This version of the model is based on the Lucas model of endogenous growth. The main feature of the Lucas model that we will study is the effect of human capital accumulation through time. The main idea in the Solow model was physical capital accumulation but in the Lucas model we will concentrate on human capital. What is human capital? Essentially human capital is the stock of education, knowledge and skills that individual consumers have. Thus, education, learning by doing and onthe- job training are all examples of human capital. But human capital differs from physical capital in one profound way it is nonrivalrous one individuals acquisition of knowledge does not preclude someone else from acquiring the same knowledge. Since the capacity for individuals to learn is theoretically limitless, the model postulates that there are no diminishing returns to human capital. Therefore it is possible for growth to continue without reaching anything akin to the Solow steady state.

The model. To begin let u represent the fraction of time an individual works and let Hs represent human capital. Therefore uHs represents the efficiency of labour i.e. the number of efficiency units of labour. This model will only have consumption as the good that delivers utility to the consumer. We will not consider leisure. Saving is also left out of the model. However if the consumer chooses not to consume in the current period then they can acquire human capital. The new human capital can be used to further consumption in the future. Therefore in the current period the consumer can consume wu Hs This is the real wage multiplying the efficiency units of labour.

Therefore total consumption will be: C= wu Hs Because the consumer can choose not to consume and acquire new human capital we will need an expression to represent this option. Thus: Hs =b(1-u) Hs this states that the amount of time not spent working (1-u) can be used to add to existing human capital Hs to get increased human capital Hs .we will call this the human capital accumulation equation. The efficiency of the education system that provides the means to enhance human capital is measured by the parameter b. If b is large then a given amount of time spent learning will add a lot to skills and knowledge. Output in the model The production function in this model uses human capital and it is human capital that firms demand. Y = zuH z is the marginal product of efficient units. The firms profit function incorporates this expression. = zuHd - wu Hd labour. The right hand side of the above is just the normal total revenue minus total cost.-all measured in real output. Simplifying the above = (z-w) Hd the condition for where uHd represents the demand for efficient

WE know that a firm continues to hire labour until profits are zero profit maximization therefore if z= w this condition is met.

How does human capital grow? We can see this directly from the Human capital accumulation equation: Hs =b(1-u) Hs If we rearrange this slightly and subtract 1 from both sides we will get the growth rate of human capital. (Hs / Hs )-1 =b(1-u)-1 Now, recall that b represents the efficiency of the education system therefore the more efficient the education system the higher the growth rate of human capital. Also notice, that the less time spent working ( i.e. the more time spent acquiring Human capital) the faster shills and knowledge are gained. These new skills can be used to produce greater output in the future. Thus the growth rate of consumption will also depend on the acquisition of human capital. The growth rate of consumption is also: ( C/C) -1 = b(1-u) -1 So: human capital and consumption grow at the same rate namely b(1-u)-1. Likewise since we only consider consumption in the model , Y= C , output also grows at the same rate as human capital. What is special about this relationship is that there are no diminishing returns the growth of the economy is determined by the time spent learning and by the education system. These are endogenous to the system. In other words the system allows for the economy to grow organically from its own knowledge base!! The diagram below presents a visual description of this.

Of course this will involve trade offs. Remember that the acquisition of human capital means individuals are not working. Therefore initially the economy sacrifices some consumption, but then is able to reach a higher standard of living in the future.

But this also means that if two countries start out with different levels of income and they both with the same parameters in this case z, b and u- they will never converge. They will, instead continue on a growth path that is predetermined by their prospective parameters.

This concludes our study of growth. Growth is the subject of many research agendas in economics and is ultimately perhaps one of the most important areas in economics. Please refer to Macroeconomics in action 7.1 in the text.