What is the endogenous growth theory?

For most of the twentieth century, economists treated technologyTechnology and economy as an external force, something that arrived on its own schedule and that no single decision could speed up. Paul M. Romer changed that view.

His endogenous growth theory argued that the forces behind long-run prosperity come from within the economy itself, shaped by the choices firms and governments make about research, education, and the institutions that support them.¹ Romer received the Nobel Memorial Prize in Economic Sciences in 2018 for this work.²

This article explains what endogenous growth theory is, what drives it, how it compares to earlier models, and where its limits lie.

Endogenous growth theory explains long-term economic growth comes from things happening inside the economy, like research, education, and new ideas, rather than from outside forces. In this view, new ideas don't just appear by chance, but from choices that companies and people make to invest in research. Market incentives push them to do this, and government policies and institutions shape how easy or hard that investment is.²

Paul M. Romer laid out this idea in his 1990 paper Endogenous Technological Change.¹ His central insight is that ideas behave differently from physical goods. Unlike a machine, which can only be used in one place at a time, an idea is non-rival, meaning one firm using it does not stop others from using it too.² Furthermore, ideas are also partially excludable, meaning firms can protect them through patents, but cannot prevent others from learning and building on them entirely. This partial protection is what gives companies an incentive to invest in things such as research and development.²

Other Nobel laureates in Economics have also contributed to and built upon endogenous growth theory, extending Romer's foundational work in important ways. Robert Lucas argued that human capital, the skills and knowledge people accumulate over time, is what drives long-run growth. His 1988 paper showed that productivity rises not only when individuals improve their own skills but also when they work alongside others with higher skill levels, creating spillovers across the whole economy.³

Philippe Aghion and Peter HowittNobel prize economics winners extended the theory further by formalizing Joseph Schumpeter's concept of creative destruction, the idea that each new innovation displaces the one before it, making older products obsolete while creating an incentive for the next wave of innovators to do the same.⁴

In the Aghion-Howitt model, a company that develops a better product or a more efficient way of producing it can outcompete rivals and earn a period of monopoly profits. That monopoly lasts only until the next innovation displaces it, which is precisely what keeps firms investing in R&D.^5,6 In 2025, Aghion and Howitt received one half of the Nobel Memorial Prize in Economic Sciences, recognized specifically for the theory of sustained growth through creative destruction.⁶

Endogenous growth models point to several forces inside the economy that shape how fast a country grows over time. Each one comes from the choices firms, households and governments make, which is what makes the theory "endogenous", or driven from within.²

Research and development

Research and development, or R&D, is the work firms and public institutions do to create new products, processes, and knowledge.⁷ A pharmaceutical company testing a new drug or an engineer designing a faster microchip are both examples of R&D in practice.

This matters because physical capital alone cannot sustain growth indefinitely. A factory owner can add more machines, hire more workers, and expand the floor space, but each additional investment eventually produces a little less than the one before it. Ideas work differently.

Once a discovery is made, it does not wear out or run out, and the next researcher picks up exactly where the last one left off. This is why investment in R&D often pays off long after the original spending, and why each generation of innovators starts further ahead than the last.^{1, 2}

Human capital

Human capital is what economists call the productive value of a person’s education, skills, and experience. The more a worker knows and can do, the more they can produce in a given hour and the faster they can pick up new ideas.⁸

In the same 1988 paper, Robert Lucas argued that human capital is the engine of growth, modeling schooling and on-the-job learning as direct inputs to economic development rather than background conditions that happen to improve over time.³

Knowledge spillovers

Because an idea can be used by many people at once, knowledge spreads across firms, industries, and countries. This means when one company invents a better production method, competitors and suppliers eventually learn from it and adapt the approach in their own operations. These spillovers raise productivity across the wider economy, even when the original innovator captures only part of the value created.^{1, 2}

Institutions and policy

Institutional interventions, such as patents regulations and research funding shape how much inn ovation actually happens. Markets on their own tend to underinvest in R&D because innovators rarely capture the full social value of what they create. A new drug benefits patients for decades, but its patent expires long before that. Well-designed government policies help close this gap, which is why they sit at the center of long-run growth.²

Learning by doing

Productivity often improves as firms and workers gain experience in production. Kenneth Arrow formalized this idea in a 1962 paper, showing that knowledge accumulates through everyday economic activity, not only inside formal research labs. The more times a factory builds a product, the better its workers and engineers tend to get at building it.⁹

Endogenous growth theory is easiest to see in sectors where knowledge keeps building on itself, research is continuous, and policy shapes the rate of discovery. Some examples are:

Silicon Valley and the digital economy

Silicon Valley shows how a single region can sustain decades of productivity growth when R&D, skilled labor, and the rapid spread of ideas come together. From semiconductors in the 1960s to software and the internet in later decades, each wave of innovation set the stage for the next.¹⁰

Moreover, universities supplied a steady flow of talent. Venture capital firms backed startups working on risky new ideas and technologies. And a culture of openness, in which competing engineers regularly shared what they were learning, helped knowledge spread quickly across the region's firms.^{10, 11, 12}This is the kind of self-reinforcing loop that endogenous growth models describe.

Pharmaceutical industry

Developing new drugs takes years of expensive research, which is why patents matter very much in this sector. Patents give companies a window to earn back what they spent on discovery before competitors can copy the molecule.^{2, 13}

Each new drug also builds on biological knowledge from earlier work, so knowledge in the field grows with every breakthrough. Empirical evidence suggests that patent protection has driven higher R&D spending on new medicines, sustaining the innovation pipeline that endogenous growth models describe.¹⁴

Public investment in research

Some research is too expensive, too long-term, or too uncertain for private firms to take on. Romer's framework suggests markets tend to underprovide R&D, creating a rationale for public investment in work the private sector would otherwise skip.²

For instance, the internet itself began as DARPA's ARPANET project in 1969.¹⁵ GPS was built by the U.S. Department of Defense beginning in the 1970s and only later opened to civilian use.¹⁶The mRNA technology behind COVID-19 vaccines was developed by Katalin Karikó and Drew Weissman at the University of Pennsylvania, work that was later recognized with the 2023 Nobel Prize in Physiology or Medicine.¹⁷

In each case, ideas funded by the public sector eventually spread into the private economy and drove growth, exactly the kind of spillover that endogenous growth models predict.

The exogenous growth model, developed by Robert Solow in the 1950s, predicted that poorer countries should grow faster than rich ones and eventually catch up, because physical capital yields diminishing returns and cheap labor attracts investment.²

But this prediction struggled to explain why growth rates across the broader world remained so persistently different. Crucially, the model treated technology as a black box, something that improved on its own schedule from outside the system, with no account of where it came from or how to speed it up.²

The endogenous growth model, developed by Romer, opened that black box. His answer was that persistent growth differences are not random but driven by choices. Countries that invest more in research, education, and innovation-friendly institutions generate more new ideas.¹

And because ideas, unlike machines, do not run into diminishing returns, those differences can compound over time. The rate of growth itself becomes something a country can influence, not just inherit.¹

Endogenous growth theory has shaped modern thinking on innovation and long-run prosperity, but economists still debate how well its main mechanisms can be measured and tested in practice.

Measurement and data limits

The things that drive growth in this framework, such as human capital, innovation, and knowledge spillovers, are hard to observe directly. Researchers usually rely on stand-ins like years of schooling to measure human capital, but these miss the quality of education that two countries might offer for the same number of school years. Better data on what students actually learn has helped, though gaps remain.¹⁸

Policy design is difficult

Even if research, education, and good incentives matter for growth, turning that insight into effective policy is another matter. Romer's work points to research and development funding, patent design, and avoiding distortionary taxes as levers that shape long-run prospects, but he has cautioned that endogenous growth theory should not be treated as a "blanket seal of approval" for every kind of government intervention.^19,20 The challenge for policymakers is choosing the specific tools that actually work in their own economy.

Endogenous growth theory transformed how economists explain long-run prosperity. By treating innovation, knowledge, and human capital as products of deliberate investment rather than accidents of history, Paul Romer gave economists a framework that matches how modern research-driven economies actually grow. His work formed the foundation of what is now called the new growth theory, and the field continues to evolve.

For more insights into economic growth and related fields by Paul Romer and other Nobel laureates, visit UBS Nobel Perspectives & Economic Views.

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Royal Swedish Academy of Sciences. The prize in economic sciences 2018: Integrating nature and knowledge into economics. NobelPrize.org, 2018.
Lucas RE. On the mechanics of economic development. Journal of Monetary Economics, 1988.
Cox WM, Alm R. Creative destruction. The Library of Economics and Liberty, 2008.
Aghion P, Howitt P. A model of growth through creative destruction. Econometrica, 1992.
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Eurostat. Research and development statistics. European Commission, 2024.
Arizona State University. Education and other human capital. Productivity and Prosperity Project, 2024.
Arrow KJ. The economic implications of learning by doing. The Review of Economic Studies, 1962.
Baily MN, Montalbano N. Clusters and innovation districts: Lessons from the United States experience. The Brookings Institution, 2017.
Lerner J, Nanda R. Venture capital's role in financing innovation: What we know and how much we still need to learn. Harvard Business School, 2020.
Smithsonian National Museum of American History. The knowledge factor in Silicon Valley. Smithsonian Institution, 2023.
OECD. Pharmaceutical innovation and access to medicines. OECD Publishing, 2018.
IFPMA. Patent protection as a key driver for pharmaceutical innovation. International Federation of Pharmaceutical Manufacturers and Associations, 2023.
Internet Society. Brief history of the internet. Internet Society, 1997.
NASA. Global positioning system history. National Aeronautics and Space Administration, 2024.
Nobel Prize Outreach. Press release: The Nobel Prize in Physiology or Medicine 2023. NobelPrize.org, 2023.
Valero A. Education and economic growth. Centre for Economic Performance, London School of Economics, 2021.
Henderson DR.Paul Romer. The Library of Economics and Liberty, 2018.
ScienceDirect. Endogenous growth model. Elsevier, 2024.

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What is the endogenous growth theory?