Growth Theory Term Paper

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Economics of New Ideas and Innovations

This research paper discusses the economics of a new idea. Without new ideas and inventions, the economy might very well become stagnant or decline, as predicted by many early economists, who did not understand that impact that ideas and innovative technology had on global markets.

Technology is endogenous in the new growth theory, which holds that technology is a function of the capital and labor used to develop technology, the technology used in that process, and the economic environment. For the purpose of this paper, technology refers to the methods and tools that are used to generate with new ideas and more efficient ways of producing goods and services.

Ideas and technical innovations are crucial to the economy. If a country wants to grow, it must create an environment that encourages entrepreneurs and innovators to generate new ideas. Creating an economic environment that promotes ideas and innovations requires the establishment of institutions that enhance growth, open trade, and the protection of new ideas through patents.

The fundamentals of the new growth theory are similar to those discussed by Adam Smith and Joseph Schumpeter. According to Smith, businesses that want to maximize profit drive the idea of specialization. Specialization then leads to larger markets and even greater specialization. This idea is consistent with the new growth theory and endogenous technology. Schumpeter focused on the role of entrepreneurs and their innovations and the changes in technologies they bring to a business.

If we assume that technology is central to growth, countries will not necessarily converge if they do not create an environment that encourages entrepreneurs and innovators to generate new ideas. Countries with high levels of capital and technology, educated and healthy labor force, and institutions that promote innovations will continue to grow at a much quicker rate than countries that do not. Governmental policies, however, can help obtaining these elements that are necessary for growth. This paper will discuss these topics, in an effort to determine how new ideas stimulate the economy and how poorer countries can use ideas and technical innovations to converge.

Introduction

In recent years, researchers have shifted their focus to one of most important questions in economics: why are some nations richer than others (The Economist, 1996)? Poverty is seen as a global concern and the surest remedy for poverty is economic growth. While growth has created problems of its own (including pollution), these problems pale in comparison with the harm caused by the economic stagnancy of poor nations, which leads to wasted lives and suffering.

For many years, economics neglected the study of growth, as early researchers concentrated on other fields, such as macroeconomic policy. It was not until the 1980s, that significant interest was dedicated to the most important issue of all. However, the past decade has shown a major interest in growth. According to Robert Lucas of the University of Chicago, "the consequences for human welfare... -are simply staggering. Once one starts to think about them, it is hard to think of anything else (The Economist, 1996)."

Early economists considered these consequences. Adam Smith's classic 1776 book was titled, "Inquiry into the Nature and Causes of the Wealth of Nations." This book laid the foundation for many present ideas for understanding growth derive. Smith believed that the main driver of growth was to be found in the division of labor, in the accumulation of capital and in technological progress. He emphasized the importance of a good legal framework, within which the market could function, and he explained how an open trading system would enable poorer countries to catch up with richer ones.

In the early 19th century, David Ricardo introduced another concept crucial for understanding growth -- the idea of diminishing returns (The Economist, 1996). He revealed how additional investment in land yielded an even lower return, suggesting that growth would ultimately come to a halt -- although trade could prevent this for a while.

Robert Solow and Trevor Swan introduced the foundations of modern growth theory in the 1950s (The Economist, 1996). Their models described an economy of perfect competition, whose output increases in response to larger inputs of capital and labor. This economy heeds the law of diminishing returns: each new bit of capital generates a lower return than the one before it.

Combined, these ideas give the neoclassical growth model, as it is known, two important implications. "First, as the stock of capital expands, growth slows, and eventually halts: to keep growing, the economy must benefit from continual infusions of technological progress. Yet this is a force that the model itself makes no attempt to explain: in the jargon, technological progress is, in the neoclassical theory, "exogenous" (ie, it arises outside the model) (The Economist, 1996). The second implication is that poorer countries should grow faster than rich ones. The reason is diminishing returns: since poor countries start with less capital, they should reap higher returns from each slice of new investment. Theory into practice."

However, today, these theoretical implications do not seem to accord with the real world. A study that showed the average growth rates since 1870 of 16 rich countries for which good long-term data exist revealed that growth has slowed down since 1970 (The Economist, 1996). In addition, modern growth rates are above their earlier long-term average. This appears to challenge the first implication that growth will slow down over time. It may be that an acceleration of technological progress is responsible for this, but this should hardly console a neoclassical theorist, as it would mean that the main driving force of growth goes beyond the span of growth theory.

This leads to the second implication -- are poor countries catching up? It seems that poorer countries have tended to grow more slowly. Having arrived at neoclassical growth theory, however, economics dismissed the subject. It had a model that was theoretically reasonable, but did not seem to support the facts. Thus, economists were unclear on how to approach the subject. It took nearly three decades for the "new growth theory" to surface.

Modern economists have questioned the law of diminishing returns in the neoclassical model. If more capital does not yield a lower return than its predecessor, growth can continue indefinitely, despite technological progress. According to Romer (The Economist, 1996), if the idea of capital is broadened to include human capital (the knowledge and skills in the workforce), the law of diminishing returns may be obsolete. For example, if a firm that invests in a new piece of equipment also learns how to use it more efficiently, there may be increasing, not decreasing, returns to investment.

In many ways, new growth theorists can show how growth might persevere without technological progress. But they argue, why assume away such progress? A second strand of new growth theory attempts to put technological progress explicitly into the model. This has prompted theorists to question innovation. Why, for example, do companies invest in development? How do the innovations of one company affect the economy as a whole?

A further deviation from the neoclassical view follows. As a general rule, companies do not bother to innovate unless it thinks it can increase its competitive advantage and profit margin. However, this account is inconsistent with the neoclassical model's simplifying assumption of perfect competition, which rules out "abnormal" profits. Thus, the new growth theorists dismiss this assumption and assume instead that competition is imperfect. Instead, they concentrate on conditions under which businesses will innovate most productively: how much protection should intellectual-property law provide an innovator, for example? In many ways, it is apparent that technological progress has assumed a central place in economists' views about growth and ideas.

However, with the latest resurgence of interest in growth theory, the original neoclassical approach is seen as a good point of reference. For example, the new theory emphasizes human capital; arguably, this merely calls for a more subtle measure of labor than the ones used by early neoclassical economists (The Economist, 1996). Basically, it is argued that if factors of production (capital and labor) are properly measured and quality adjusted, the neoclassical approach yields everything of value in the new theory. This proves a basic theory in economics: the mainstream first takes affront at new ideas, then reluctantly draws on them, and eventually claims to have invented them in the first place.

This paper aims to address the issues surrounding existing growth theories, in an effort to determine why some nations are more advanced than others, what factors determine economic growth and how individuals, businesses and nations can increase productivity. The goal of this paper is to determine what impact new ideas and inventions have on the economy, as well as the extent to which these ideas should be protected against competition.

Literature Review

Neo-Schumpeterian Theory

Neo-Schumpeterian theory clearly focuses the study of economics of innovation on questions related to how and why the introduction and diffusion of new ideas with economic value changes the basis of competition. Biotechnology, for…[continue]

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