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