Endogenous growth models try to take the next step and accommodate
fact 4. Work in this direction started in the 1960s. For example, Karl Shell
(1966) made the point about replication noted above, showing that it left no
resources to pay for increases in A. He proposed a model in which A is
financed from tax revenue collected by the government. Recent endogenous
growth models have tended to follow Arrow (1962) and emphasize the private
sector activities that contribute to technological advance rather than public
sector funding for research. A subset of these models has tried to incorporate
14 Journal of Economic Perspectives
both fact 4 (that technological advance comes from things people do) and fact 5
(the existence of monopoly rents). These are sometimes referred to as neoSchumpeterian
models because of Schumpeter's emphasis of the importance of
temporary monopoly power as a motivating force in the innovative pro~ess.~ In
addition, there are two other distinct kinds of endogenous growth models.
Spillover models have already been mentioned. Linear models will be described
be10w.~
With the benefit of hindsight, it is obvious that growth theorists would
eventually have to do what economists working at the industry and firm level
have done: abandon the assumption of price-taking competition. Otherwise,
there is no hope of capturing fact 5. Even at the time, the point received at least
some attention. In his 1956 paper, Solow remarked in a footnote on the
desirability of extending the model to allow for monopolistic competition. One
of his students, William Nordhaus (1969), subsequently outlined a growth
model that did have patents, monopoly power, and many firms. For technical
reasons, this model still invoked exogenous technological change, so it is not
strictly speaking a model of endogenous growth-but it could have been
extended to become one. Because a general formal treatment of monopolistic
competition was not available at the time, little progress in this direction took
place for the next 20 years.
Even though it is obvious in retrospect that endogenous growth theory
would have to introduce imperfect competition, this was not the direction that
the first models of the 1980s pursued. Both my model (1986) and Robert
Lucas's mode1 (1988) included fact 4 without taking the final step and including
step 5. In both of these models, the technology is endogenously provided as a
side effect of private investment decisions. From the point of view of the users
of technology, it is still treated as a pure public good, just as it is in the
neoclassical model. As a result, firms can be treated as price takers and an
equilibrium with many firms can exist.
This technique for introducing a form of aggregate increasing returns into
a model with many firms was first proposed by Alfred Marshall (1890). To
overturn the pessimistic predictions of Malthus and Ricardo, he wanted to
introduce some form of aggregate increasing returns. To derive his downward
sloping supply curve from an industry with many firms, Marshall introduced
the new notion of increasing returns that were external to any individual firm.
External effects therefore entered into economics to preserve the analytical