The first version of endogenous growth theory is the AK model, which offers a simple yet powerful departure from the Neoclassical framework.

4.1. The Central Idea: Eliminating Diminishing Returns

The AK model’s core insight is to eliminate the problem of diminishing returns. It does this by defining “capital” in a very broad sense.

• In the AK model, “capital” (represented by the letter K in the production function Y = AK) is not just physical tools and machinery.
• It is a composite stock that lumps together physical capital, human capital (the skills and education of the workforce), and intellectual capital (the stock of technological knowledge).

By bundling knowledge and skills into the definition of capital, the model asserts that as this broad stock of capital is accumulated, there is no reason for its marginal product to diminish. Part of the accumulation process is the very technological progress needed to counteract diminishing returns.

4.2. The Major Implication: Policy Can Affect Long-Run Growth

This change has a radical implication. In the AK model, an economy’s long-run growth rate depends directly on economic factors like the saving rate. This means that economic policies—for example, tax incentives that encourage saving and investment—can have a permanent effect on an economy’s long-run growth rate. This stands in sharp contrast to the Neoclassical model, where policy could only affect the level of income, not its long-run growth rate.

4.3. The Main Weakness: A Lack of Convergence

The model’s primary weakness is its prediction regarding convergence. Because there are no diminishing returns, the AK model predicts that poorer countries with less capital will grow at the same rate as richer countries. This means that income gaps between rich and poor countries will persist forever, and poorer countries will never catch up. This contradicts the patterns of conditional convergence that are observed in the real world.

To better model the real world, economists needed theories that could explain both sustained growth and convergence by focusing explicitly on the process of innovation.