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Endogenous Growth Theory and the Success of Charter Cities

April 11, 2021
Editor(s): Nuoya Liu
Writer(s): Annie Zhu, David Li, Kailin Tan, Kaiyue Chen

1. Endogenous Growth Theory

The historical backdrop for the development of endogenous growth theory (EGT) was a period of stagflation in the 1970s, aptly named as both unemployment and inflation skyrocketed synchronously. This falsified common notion of macroeconomics at the time, which placed its faith in the Phillips curve and the Keynesian trade-off of unemployment and inflation. Furthermore, the rise of the so-called “East Asian tiger economies” crippled postulates of Robert Solow and Trevor Swan’s (1956) neoclassical growth theory, thus paving the way for a revolutionary change in the paradigm of growth economics [1].

Contrasting to prior beliefs, the endogenous growth theory (EGT) draws attention to the role of internal forces, e.g. human capital and innovation, within an economy’s long run growth (Howitt, n.d.). The model was built upon seven key variables and evolves from the following basic form.

1.1 Mathematical Derivation

The Solow neoclassical growth model suggests that in the long run, the amount of capital an economy has accumulated determines the level of output it can produce, which, in turn, determines its saving and investment during that period. Mathematically, physical and human capital accumulation can be represented by \( K_{t+1} – K_t = s_K Y_t – \delta K_t \) and \( H_{t+1} – H_t = s_H Y_t – \delta H_t \), respectively.

Along a balanced growth path, both types of capital will grow at a constant rate \( g\).

\[ g=(K_{t+1}-K_t)/K_t =(H_{t+1}-H_t)/H_t \]

From above formulas we can get the intensity of human capital relative to physical capital:

\[ \phi^* = H_t / K_t = s_H/s_K \]

On top of that, transition dynamics take place in cases where the initial intensity \( \phi_0 = H_0 / K_0 \) differs from \( \phi^* \) To be specific, \( \phi \) will keep adjusting by changing either the speed of human capital accumulation or physical capital accumulation until eventually converging to the balanced growth path intensity \( \phi^* \).

Given the production function \( Y= A K^\alpha H^{1-\alpha} , 0<\alpha<1 \), diminishing returns are present to both physical and human capital. Higher technology is also associated with higher output for any given level of inputs. Substituting \( H_t=\phi^* K_t \) into the production function:

\[ Y_t = A K_t^\alpha H_t^{1-\alpha} =A K_t^\alpha (\phi^* K_t)^{1-\alpha} = A (\phi^*)^{1-\alpha} K_t \]

It can be shown that \(K_t\) and \(H_t\) appear in constant proportions along the balanced growth path. Hence, sustained growth may be achieved assuming no diminishing return to capital.

From above formulas, one can also arrive at the endogenous growth rate: \( g^*=s_K^\alpha s_H^{1-\alpha} A-\delta \), which depends on the economy’s state of technology, as well as the saving rate and depreciation rate. Hence, the endogenous growth rate emphasises the need for government to provide incentives and subsidies for business to boost research and development, technological advancement. It further indicates the crucial role of investment in human capital through education or training programs in economic development.

1.2 Academic Development and Limitations

EGT was initially pioneered by Professor Paul Romer in 1986 through a publication in the “The Journal of Political Economy”. Its premise was a different approach to understanding capital, and a shift away from the normalised assumption of diminishing returns to capital. This theory introduces a dichotomy for understanding this new concept of capital – the traditional “physical” capital retaining diminishing returns; and “knowledge”, or a notion later termed human capital, which exhibits increasing returns. Romer gives two enlightening examples to elaborate on his premise. Firstly, this increasing returns to knowledge assumption means that doubling inputs into knowledge production (R&D) will cause the output of knowledge to be more than double the existing stock, thus suggesting the existence of a positive externality. The second example demonstrates the compounding yet slow-moving nature of knowledge accumulation. Specifically, although nuclear energy production can eventually be perfected with low levels of GDP contribution to its research, this knowledge cannot be produced within a year regardless of contribution to research. This revolutionary shift in how capital should be perceived led to several insightful conclusions that ought to be considered carefully by policymakers.

The most significant of these conclusions is the mathematical conclusion reached by Romer in his 1986 paper, in that a model with increasing returns features both a competitive equilibrium \( ( E^* ) \) and a socially optimal equilibrium \( (E_s*) \), and that a set of government subsidies can be used to enforce as . This is diametrically opposed to the intuitive understanding that all of society’s income would be used to pursue knowledge accumulation. This not only diagnoses a terminal lack of R&D as the source of poverty in developing economies, but also provides the simple remedy of subsidising knowledge accumulation. This theory also served as the catalyst for further research and second-generation models. Examples include Aghion and Howitt’s (1992) Schumpeterian Growth Theory, and Jones’ (1995) model that includes a R&D sector.

However, EGT is not a perfect theory, and its limitations are also discussed extensively within the literature. Paul Krugman (2013), one of our generation’s most eminent economists, points out the immense difficulty associated with performing empirical research relating to EGT. The following quote summaries both his, and that of other economists’, criticism rather aptly: “too much of it involved making assumptions about how unmeasurable things affected other unmeasurable things”.  Fine (2000) also argues that the existence of multiple equilibria and complex mathematical analysis as undesirable. However, EGT’s impact on both public and political discourse on how to stimulate dormant economies testifies to its appeal. Indeed, Romer’s pragmatism in advocating for charter cities, based on the premises of EGT, demonstrates the capacity of EGT to capitulate healthy dialogue amongst the world’s leading economists and policymakers.

2. Application of EGT: Charter Cities

2.1 Charter City Introduction

A charter city is a city that has been granted special jurisdictions to create a new governance system. It is a public policy tool to help emerging markets develop the institutions that can serve as the foundation for economic success. Charter cities do so by allowing countries to implement new policies on uninhabited lands. These policies are often specifically designed to attract investors who will build out the infrastructure, firms who will create jobs for residents, and residents who will come and live there permanently. Simply speaking, a host country would provide land, a source country would provide residents, and a guarantor would provide the assurance that the new city’s charter would be enforced and law-abiding. In addition, all infrastructure – including schools and hospitals – would be owned and operated by private investors and developers. With these three stakeholders working together, charter cities set out to boost economic growth to low socio-economic status countries through models of good governance and wealth creation.

As previously explained, endogenous growth theory argues a type of economic growth that is generated from within a system, and that such economic growth is a direct consequence of internal processes rather than external. Its main argument is that the increase of a nation’s human capital will facilitate economic growth as it leads to technological innovation and more efficient means of production.

Indeed, charter cities are based on the endogenous growth theory. They essentially function as a tax-free, special reform zone specifically designed to attract foreign investment and opportunity seekers. By attracting foreign investment, charter cities also attract the knowledge, skills and physical capital that follows. Through this initial inflow of resources, infrastructure can be built quickly and efficiently, providing opportunities for residents to learn and benefit from such infrastructure and knowledge. This spurs the accumulation of human capital within the system, allowing for charter cities to achieve endogenous growth.

2.2 Case Study: Hong Kong

The city closest in resemblance to such a concept is Hong Kong. Although Hong Kong’s success is not deemed alone to its “role as a charter prototype”, it exemplifies great potential for the charter city model (Cheong & Goh, 2013).

Paul Romer consistently utilized Hong Kong as an example to draw contrast on how meta- rules and choices are the key drivers of growth and economic progress to the overall country. Firstly, Hong Kong’s history gave room for partnerships between nations – specifically in this case, between Britain and China. The partnership gave leverage to the existence of new rules and policies that provide opportunities for any willing person to take residence or foreign companies to invest. Next, it was these special economic zones (SEZ), e.g. Shenzhen, that adopted similar new rules and systems, which changed its state from a small village to an urbanized city (Romer, 2010). These SEZ allowed the spread and adoption of new rules to further foster environments of GDP growth for a country. What made Hong Kong and these SEZ differ from colonialism was that it was a choice to live there, as well as the allowance of opting in and out (Romer, 2010).

Supporting evidence presented was the growth in income per capita in China from 3 percent relative to the United States to a near 15 percent in just over 40 years (Romer, 2010). Not only did its GDP per capita grow, but correspondingly China also showcased advancements in the technological frontier and reduced poverty (Romer, 2010). 

However, some questioned the legitimacy of charter cities, and proposed the following arguments as to why Hong Kong is not a full representation of a charter city. Namely, Hong Kong also gained special advantage from its geographic position, with a natural harbor for a trade port. Conjointly, “the growth of Hong Kong as an international financial centre is increasingly built on bilateral investment and financial flow with China” (Cheong & Goh, 2013).

Nonetheless, charter cities have demonstrated significant success for the endogenous growth theory to be applied in a country’s economic development, where cities like Hong Kong maintain sustained growth and resultantly prosper from its positive net investments into capital.


[1] The two postulates were absolute convergence, and the notion long-term economic growth could not be sustained by capital accumulation.

References

Aghion, P, Howitt, P. (1992), ‘A Model of Growth Through Creative Destruction’, The Econometrica, vol. 60, no. 2, pp. 323-351.

Cao, L. (2019). Charter Cities. William And Mary Bill Of Rights Journal, 27(3), Article 6.

Cheong, K. & Goh, K. (2013). Hong Kong as charter city prototype – When concept meets reality. Elsevier Lt, 35, pp.100-13.

CFI. (n.d.). Endogenous growth theory. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/economics/endogenous-growth-theory/

Fine, B 2000, ‘Endogenous Growth Theory: A Critical Assessment’, The Cambridge Journal of Economics, vol. 24, no. 2, pp. 245-265.

Fuller, B., & Romer, P. (2012). Success and the City: How Charter Cities Could Transform the World. Macdonald-Laurier Institute Publication.

Howitt, P. (n.d.). Endogenous growth. Retrieved from https://www.brown.edu/Departments/Economics/Faculty/Peter_Howitt/publication/endogenous.pdf

Jones, C 1995, ‘R&D-Based Models of Economic Growth’, The Journal of Political Economy, vol. 103, no. 4, pp. 759-784.

Krugman 2013, ‘The New Growth Fizzle”, NY Times Opinion Pages Blog, NY Times, 5 November 2020, https://krugman.blogs.nytimes.com/2013/08/18/the-new-growthfizzle/?_r=0

Romer, P 1986, ‘Increasing Returns and Long-Run Growth’, The Journal of Political Economy, vol. 94, no. 5, pp. 1002-1037.

Romer,P. (2010). Technologies, rules, and progress: The case for charter cities (No. id: 2471) https://www.stern.nyu.edu/sites/default/files/assets/documents/con_035432.pdf

Sagar, R. (2016). Are Charter Cities Legitimate?. The Journal of Political Philosophy, 24(4), pp.509-529.

Solow, R 1956, ‘A Contribution to the Theory of Economic Growth’, The Quarterly Journal of Economics, vol. 70, no. 1, pp. 65-94.

Swan, T 1956, ‘Economic Growth and Capital Accumulation’, The Economic Record, vol. 32, no. 2, pp. 334-361.

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Meet our authors:

Nuoya Liu
Editor
Annie Zhu
Writer
David Li
Writer

Hi! My name is David, and I am a second year BCom student majoring in Economics and Finance. Outside of uni, I enjoy playing guitar, watching the F1 and making cocktails.

David Li's Articles
Kailin Tan
Writer
Kaiyue Chen
Writer