Endogenous growth model

Endogenous growth model:

Robert E. Lucas, Paul Romer, and Robert J. Barro have done a lot of research on the new endogenous theory. The model is based on key basic assumptions namely positive return rates on human capital and constant return rate to capital.

Returns to human capital have guaranteed increase but the growth rate is dependent on the specific kind of capital in which a country invests.

Thus theory argues that heavy investment in research and development is the key to technological advancement and hence even if an economy has abundant labour and capital with stead rates of return, it will not develop for lack of technological progress. Romer (1990) argues that the development of qualitative labour force brings about new ideas and products which bring forth technological progress. He further argues that economies with large labor forces tend to grow faster as they experience a higher rate of introduction of new goods and services. In another argument, Rebelo and Barro (1990) have noted that per capita growth and investment ratio move simultaneously. Further, it is indicated that is a country has to grow adequately, human capital is very important and that the two are achieved in the dimensions of health and education. Barro notes that higher levels of human capital development are achieved when a country grows faster. This is because physical capital undergoes rapid expansion to match high human capital endowment. Also, a country is better positioned to acquire and introduce the superior technologies which have been developed in other countries.

Further, Warner and Sach (1997) have postulated that rapid increases in levels of human capital development may lead to fast transitional growth. This perhaps explains why majority of the developing countries have excessive labor supply but lack physical capital required to achieve growth. In developing countries, foreign direct investment (FDI) seems to be the main way of utilizing and developing advanced technologies. Many of developing countries have an excess supply of labour, but on the other hand lack of physical capital to achieve growth. FDI is one of the sources to exploit and develop advanced technologies in developing economies.

The implication of this theory is that good economic policies that embrace competition, openness, innovation and change have the potential to promote rapid economic growth.

This is also called the new growth model that was developed as a result of the rising criticism to neo classical model. The context of the model is that the policy measures are influential to the economy growth rate on the long run. A good example are the subsidies on the extent of research as well as development or even education have the potentials to improve on the rate of growth considering some of the models of endogenous growth therefore leading to the increase in incentives for innovation.

Determinants of economic growth:

Majority of the theoretical approaches on this subject have looked at other macro non-economic factors which have an influence on the economic performance of a country. Such factors are political systems, socio-cultural issues and geographical factors. Investigation of these factors has revealed a lot of interesting results. First, the choice of an investment is by far considered the most essential determinant of economic growth. Both the exogenous and endogenous models of growth have identified it as propeller of growth. In contrast the neo-classical growth model argues that investment only affects the output level in the short run. Another important aspect of economic growth is the human capital. Its accumulation is a major factor in the development process and it is realized through education and training. Education and training stimulates economic development by raising the output per worker and hence heavy investment in human capital is essential in stimulating economic growth.

The human capital is influenced by public school and health programmes. The higher the quality of education, the higher the educated work force and this has the effect of attracting potential foreign direct investments from other countries which are well developed.

The neo-classic growth model has it that quantity and quality of both human and physical capital employed affect the total output of an economy. When human capital reaches the full employment level, economic growth can be guaranteed by way of improvement in the quality of labour force or the capital stock.

Most studies have identified technological advancement to be the key driver of economic growth more especially in introducing new factors like knowledge, public infrastructure and innovations all of which are the stimulants of economic growth.

Lucas and Romer, in their study concluded that economic growth is in the long run stimulated by implications of both monetary and fiscal policies and according to the endogenous growth models suggest, an economy will not converge because of the increasing returns to scale.

Foreign Direct Investment has also been widely credited for the rapid rate of technology transfer and fast economic growth. This has been stressed in several models of the endogenous growth theory.

Effects on location of Foreign Direct Investment

The host market economy can be competitive if it is broad enough. Stiff competition reduces the possibility of monopoly proceeds and hence inhibits the possibility of foreign direct investors benefiting from abnormal returns.

However, foreign direct investments can benefit from monopoly in those economies which are narrowly specialized and less competitive in relation to foreign investments. Domar postulates that large numbers of small industries in an economy, whose research capability is too small, cannot maximize economic growth.

The location of foreign direct investment can be influenced by a number of factors. First and foremost is the size of the market in the potential host economy. Billington (1999) argues that expanding into a foreign market results into more sales revenue and a higher market share. Gross domestic product is usually used as the measure of the market size. Researches on several countries have shown that the size of the market share has a direct positive impact on foreign direct investments.

Another determinant of location of FDI is the availability of labour. Labor availability is normally measured by productivity and cost. Haaland has held that the flexibility of the labor market determines the decision for location of foreign firms and according to Wheeler (1992), the cost of labor as measured the hourly wage rate have adverse effects on foreign direct investments. To offset high labor costs high production levels have to be reached.

Macro-economic factors normally affect foreign direct investments mainly through exchange rate and corporate tax. In almost all cases high corporate tax has a negative effect on the choice of location for FDI since profits are reduced. In addition fluctuation of exchange rates in the host country makes investments more risky. Depreciation in the host country’s currency makes it easier for the foreign firms to set up their businesses but on the other hand reduces the value of the profits repatriated to mother countries.

A government can influence the location of an FDI firm by way of financial or non-financial policies. It can provide an enticement so as to attract foreign direct investments.

Another determinant for allocation of foreign direct investment is the level of infrastructural development. High level of infrastructural development creates an impression of urbanization a key factor envied by foreign investors. The underlying logic is that the foreign investors presume a large number of consumers in an urbanized economy.