The endogenous growth literature has explored several forces that offset the propensity for diminishing returns to capital. Explanations that have gained attention recently include knowledge and allow technological progress to be endogenous. One explanation is that there
are spillover effects to investments in capital, broadly
defined, that prevent the returns to investments from
falling (Romer 0000). Firms learn from the process of
making investments. Workers’ learning on the job creates
knowledge that becomes publicly available and spills
over to other firms. Thus, “learning by doing” increases
the stock of knowledge and human capital, offsetting the
tendency for diminishing returns. Another explanation is
that imperfect competition in markets for innovative
goods allows firms temporarily to earn above-normal
profits, encouraging technological progress and sustained growth. Innovation shows up as increases in the
quality of goods and inputs or as specialization. With the
ability to differentiate their product, innovative firms
achieve market power over their prices. The incentive to
innovate is to gain market power in order to earn the
above-normal profits until competitors catch up. The
desire to get ahead and then stay ahead is self-reinforcing and leads to sustained growth. Simply put, it is the
battle over market share and profits through constant
innovation that propels economies forward.