Economics of New Ideas and Innovations in Growth Theory

Introduction

Without new ideas and inventions, the economy might very well become stagnant or decline — a fate predicted by many early economists who did not appreciate the impact that ideas and innovative technology have 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 it, the technology employed in that process, and the prevailing economic environment. For the purposes of this paper, technology refers to the methods and tools used to generate 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 such an environment requires the establishment of institutions that enhance growth, promote open trade, and protect 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 seeking to maximize profit drive specialization, which then leads to larger markets and even greater specialization — an idea consistent with new growth theory and endogenous technology. Schumpeter focused on the role of entrepreneurs, their innovations, and the technological changes they bring to business.

If technology is indeed central to growth, countries will not necessarily converge unless they create an environment that encourages entrepreneurs and innovators. Countries with high levels of capital and technology, educated and healthy labor forces, and institutions that promote innovation will continue to grow far more quickly than those that do not. Government policies, however, can help countries acquire the elements necessary for growth. This paper discusses 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.

In recent years, researchers have shifted their focus to one of the 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 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 this most important issue. 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 wrestled with these consequences. Adam Smith's classic 1776 work, An Inquiry into the Nature and Causes of the Wealth of Nations, laid the foundation for many present-day ideas about understanding growth. Smith believed that the main driver of growth lay in the division of labor, the accumulation of capital, and technological progress. He emphasized the importance of a sound legal framework within which markets 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 showed how additional investment in land yielded ever-lower returns, suggesting that growth would ultimately come to a halt, although trade could forestall this outcome for a time.

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 — an economy subject to the law of diminishing returns, in which each new unit of capital generates a lower return than the one before it.

Combined, these ideas give the neoclassical growth model 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 "exogenous" in neoclassical theory — it arises outside the model. The second implication is that poorer countries should grow faster than rich ones, because, given diminishing returns, countries starting with less capital should reap higher returns from each unit of new investment (The Economist, 1996).

However, these theoretical implications do not accord with the real world. A study of average growth rates since 1870 across 16 rich countries for which good long-term data exist revealed that growth has actually slowed since 1970 (The Economist, 1996), yet modern growth rates still exceed their earlier long-term average. This appears to challenge the first implication that growth will decelerate over time. An acceleration of technological progress might explain this, but that explanation provides little comfort to a neoclassical theorist, since it would mean that the main driving force of growth lies beyond the reach of the theory itself.

This leads to the second implication — are poor countries catching up? The evidence suggests that poorer countries have tended to grow more slowly, not faster. Having arrived at neoclassical growth theory, economists found themselves with a model that was theoretically plausible but did not fit the facts. It took nearly three decades for the "new growth theory" to surface.

Modern economists have questioned the law of diminishing returns embedded in the neoclassical model. If additional capital does not yield a lower return than its predecessor, growth can continue indefinitely even without exogenous technological progress. According to Romer (The Economist, 1996), if the concept of capital is broadened to include human capital — the knowledge and skills embodied in the workforce — the law of diminishing returns may become obsolete. For example, a firm that invests in new equipment and simultaneously learns to use it more efficiently may experience increasing, not decreasing, returns to investment.

New growth theorists can thus show how growth might persist without exogenous technological progress. But they also argue, why assume away such progress? A second strand of new growth theory attempts to incorporate technological progress explicitly into the model, prompting theorists to examine the economics of innovation. Why, for example, do companies invest in research and development? How do the innovations of one company affect the economy as a whole?

A further departure from the neoclassical view follows. As a general rule, companies will not innovate unless they expect to gain a competitive advantage and an enhanced profit margin. This, however, is inconsistent with the neoclassical model's assumption of perfect competition, which rules out "abnormal" profits. New growth theorists therefore dismiss this assumption and instead focus on the conditions under which businesses will innovate most productively — for instance, how much protection intellectual-property law should provide an innovator. In many ways, technological progress has assumed a central place in economists' thinking about growth and ideas.

With the latest resurgence of interest in growth theory, the original neoclassical approach serves as a useful reference point. The new theory's emphasis on human capital, for example, can be seen as calling for a more subtle measure of labor than those used by early neoclassical economists (The Economist, 1996). If factors of production — capital and labor — are properly measured and quality-adjusted, neoclassical analysis yields much of what is valuable in the new theory. This illustrates a recurrent pattern in economics: the mainstream first resists new ideas, then reluctantly draws on them, and eventually claims to have originated them.

This paper aims to address the issues surrounding existing growth theories in an effort to determine why some nations are more economically advanced than others, what factors determine economic growth, and how individuals, businesses, and nations can increase productivity. The central goal 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.