Economics of New Ideas and Innovations in Growth Theory

Introduction

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.

Neo-Schumpeterian Theory and Romer's Ideas of Economic Growth

Neo-Schumpeterian theory focuses the study of the economics of innovation on questions related to how and why the introduction and diffusion of new ideas with economic value change the basis of competition. Biotechnology, for instance, has clearly affected the research and development (R&D) activities and product lines of pharmaceutical companies, while simultaneously opening opportunities for small, specialized firms to sell knowledge and products that connect large firms with universities.

More and more economists are questioning what sparks growth, and many base their ideas on those of Joseph A. Schumpeter, an Austrian economist and Harvard University professor (Farrell, 1994). Like Schumpeter, these economists concentrate on technology, innovation, and knowledge. "The one fact that comes from economic history is the ability of the human mind to break through barriers that weren't imaginable 50 years ago," says Joel Mokyr, economic historian at Northwestern University (Farrell, 1994).

In the past, mainstream economics struggled with the question of what determines long-term growth. In the late 1950s, Nobel laureate Robert M. Solow of the Massachusetts Institute of Technology suggested that increases in an economy's labor supply and capital stock only partially explain economic growth. He attributed the remainder to technological change but was unable to describe why such change occurred.

The Schumpeterians take traditional economics to a new level by examining the driving factors of technological change (Farrell, 1994). These economists are concerned with how growth is shaped by support for technical innovation, educational institutions, and rewards to entrepreneurs for new ideas. A leading Schumpeterian is Paul Romer of the University of California at Berkeley.

According to Paul Romer, new ideas embedded in technological change drive economic growth and enable societies to escape the grim futures that earlier economists often predicted (Kelly, 1996). In Romer's view, the world is not defined by scarcity and limits on growth, but is instead filled with endless opportunity, where new ideas produce new products, new markets, and new possibilities for creating wealth. "Old growth theory says we have to decide how to allocate scarce resources among alternative uses," stated Romer. "New growth theory says, 'Bull! We're in this world, it's got some objects, sure, but it's got these ideas, too, and all that stuff about scarcity and price systems is just wrong'" (Kelly, 1996).

Romer was first recognized in the economics field in 1986, with the first in a series of innovative papers that revived the study of economic growth, which had been dormant for decades. "Paul single-handedly turned it into a hot subject," according to MIT economist and Nobel laureate Robert Solow (Kelly, 1996). During the 1950s, economists had developed simple models concluding that technological change accounted for approximately 80% of economic growth, yet they failed to specify what technology meant or how to encourage its development.

These early economists were more concerned with preventing another depression and focused on controlling inflation and unemployment rather than studying technology. As the Great Depression faded into history, economics students sought new challenges. Romer, who had studied physics in college, became curious about what exactly drives economic growth.

For many years, mainstream economists expected growth in industrialized countries to decline or at least plateau, anticipating diminishing returns — the idea that the growth contributed by each additional farm, factory, or employee declines over time. Yet the economy continuously defied these expectations, causing many to doubt the validity of such predictions. By the time Romer began studying economics, new economies to the East, led by Japan, were explosive. As Romer observed: "I looked at the problem and said, 'This theory doesn't have any clothes on,' and proceeded to start work on it" (Kelly, 1996).

Romer's main contribution to economics is the construction of a model that exposes the important role ideas play in driving growth. Like many economists, he divides the world into two parts: physical objects and ideas. Objects — from large steel mills to carbon and oxygen atoms — are scarce and subject to the law of diminishing returns, making them incapable of driving sustained economic growth on their own. Ideas, however, can. Human beings, Romer argues, have a nearly infinite capacity to reconfigure physical objects by creating new ideas for their use. New ideas on how to increase the power of a hard drive, for example, enable people to boost productivity, develop new profit opportunities, and ultimately drive economic growth.

The best thing about ideas, according to Romer, is that they are virtually limitless. "On the ideas side you have combinatorial explosion," he says. "There's essentially no scarcity to deal with" (Kelly, 1996). For example, the number of possible bitstreams that can be turned into a CD-ROM reaches something in the range of 10 to the power of 1 billion, virtually ensuring that people will always find new software. "There isn't enough mass in the universe to make that number of CDs," he observes.

To illustrate his point, Romer discusses a thought experiment involving chemical reactions. Using chemical processes, humans can reorder carbon and hydrogen into new polymers and proteins. To test how far this can go, Romer imagines a chemical refinery of the future — small, mobile, capable of sourcing its own inputs, maintaining a constant temperature, self-healing, and able to replicate itself without human intervention. He then points out that this refinery already exists: the milk cow. If hundreds of millions of years of evolution can produce such a machine, there must be an endless number of undiscovered ideas for combining atoms. Scientists, for example, are already altering cattle DNA in attempts to produce cows that secrete lactoferrin into their milk — demonstrating that the world has barely scratched the surface of the infinite ideas that could reshape the economy (Kelly, 1996).

New technologies like biotechnology help diminish the old image of diminishing returns. Traditional economists believe that growth has inherent limits, but new technologies appear to create increasing returns, because research generates new ideas that spawn new products. There is an additional benefit from increasing returns: declining costs. A new idea that produces a new product can make subsequent units easier and cheaper to produce. For example, including research costs, the first copy of Windows NT may have cost Microsoft $150 million. However, each copy produced thereafter cost virtually nothing.

As Kelly (1996) observed, early software users intuitively grasped this property of software when sharing copies among friends. This is where Romer diverges from classical theory: old-school economics assumes that companies charge for a product exactly what it cost to produce the last unit. If that were the case, software firms would effectively give their goods away. However, when industries face high research costs and low production costs, they tend toward monopoly — a situation in which companies charge more than the marginal cost of production. "If you forced anyone in the world of ideas to sell their product at the cost of producing the last unit, they'd go bankrupt," says Romer (Kelly, 1996).

According to traditional economists, monopolies should not arise because competition is assumed to be perfect: many small firms compete, none can set prices, market entry is costless, and prices reflect the cost of production. When it comes to technology, however, this framework is obsolete. Because research costs are so high, the cost of market entry can be very high as well. As a result, large firms engage in intense competition, funding new discoveries while paying for old ones, and charging far more than the cost of production. The economics of monopolistic competition is the economics of today's technology age.

Romer believes that if the goal is to encourage the production of new ideas — or "nonrival goods," which are nonrival because everyone can use them simultaneously — policymakers face a fundamental tension. Setting a high price encourages research and innovation, but a low price encourages broad use. "The economic problem," Romer says, "is really about configuring all our institutions so that we search efficiently through this space of possible ideas, finding better and better ones" (Kelly, 1996). He argues that companies must receive some monopoly profits for developing new ideas, given the considerable risks they take. Without the incentive of potential large profits, companies would not conduct such extensive research.

At the same time, Romer champions government funding for basic research and advocates reforming patent and copyright laws to limit monopolies on new technologies. The appropriate balance provides enough incentive for companies to invent while enabling other individuals and companies to access the ideas that research produces. The main point presented by Romer is that, in order to develop successfully, countries must be open to new ideas and utilize the benefits of the latest technologies. They must embrace free trade and encourage investment by large corporations, which bring knowledge of industrial organization, international markets, and product differentiation — all essential for developing nations to succeed economically. One of the greatest benefits of free trade, in Romer's view, is access to new ideas.

The Neoclassical Growth Model and Endogenous Growth Theory

Knowledge impacts the economy in several ways. Most importantly for the practice of economics, knowledge and innovation have long been considered the primary sources of economic growth. The literature on growth economics covering knowledge, innovation, and technology is vast; accordingly, this paper focuses on information directly pertinent to the central argument.

Early economic growth theory was primarily based on the concept of decreasing marginal returns — the idea that continually increasing inputs eventually reaches a point where each additional unit of input costs more than it contributes to the production process. "When marginal returns keep falling until they are zero, long-run economic growth is only possible if some 'exogenous' factor is assumed to be present. This could, for example, be technical change that… is given by 'God and the engineers'" (Verspagen, 1999). Without such an exogenous factor, investment would cease and, according to economic theory, growth would halt.

The neoclassical growth model is criticized by economists such as Romer because it fails to explain observed international differences in per capita income. Aside from capital, the only determinant of per capita income in the model is the effectiveness of labor — a variable whose meaning remains unclear. Capital alone cannot explain income differences because the required variation in capital per capita would need to be implausibly large. For example, output per worker in America is approximately ten times greater than in India. If we set the effectiveness of labor equal to one, accounting for a tenfold income difference would require capital per worker to differ by a factor of 1,000 (when the output elasticity of capital is 0.3) or 100 (when it is 0.5). Yet capital per worker in the United States is no more than 20 times larger than in India.

If capital cannot explain differences in income per worker, that leaves accumulated technology — represented by improvements in labor efficiency — as the explanatory variable. However, the neoclassical model is incomplete because the rate of increase in this technology is exogenous, leaving many economists dissatisfied with the framework.

Modern growth research has therefore focused on endogenous mechanisms to explain growth, particularly the roles of knowledge generation and human capital accumulation. According to Romer's model of endogenous growth, the economy contains two production sectors: a goods-producing sector, which uses human capital, knowledge, and labor; and a knowledge-producing sector, which uses the same factors to expand the stock of knowledge. Capital and labor must be allocated between these two sectors. Importantly, the stock of knowledge is nonrival — once accumulated, it is available to both sectors simultaneously.

Evolutionary economists offer an interesting perspective on knowledge-driven growth. They regard an idea as knowledge rather than marketable information: "It is not a commodity, but instead is embedded in a variety of learning processes and organizational structures which are specific to individuals, firms or institutions. Because of this embeddedness, it cannot be easily transferred" (Blankenburg, 2000). From this perspective, it is not the transfer of information per se that drives economic growth, but the capacity to convert an idea into something that generates utility or profit. This typically requires cooperation across different sources of knowledge — a process in which "positive feedback effects from cooperation (rather than negative spillovers between firms) are at the heart of the innovation process" (Blankenburg, 2000).

Modern economists believe that improvements in productivity can accelerate innovation and spur additional investment in human capital (Tutor2u Limited, 2003). Endogenous growth theorists argue that government and private-sector institutions must nurture innovation and provide incentives for individuals to develop new ideas. There is also a central role for knowledge as a determinant of economic growth: endogenous growth theory predicts positive externalities and spillover effects from the development of a high-value-added knowledge economy capable of sustaining a competitive advantage in global growth industries.

The main points of endogenous growth theory are as follows: (1) the rate of technological progress should not be treated as a given in a growth model — appropriate government policies can permanently raise a country's growth rate, particularly through higher levels of market competition and a faster pace of innovation; (2) there are potential increasing returns from higher levels of capital investment; (3) private investment in R&D is the central source of technical progress; (4) protection of property rights and patents can provide incentives to engage in R&D; and (5) investment in human capital — education and training of the workforce — is an essential ingredient of growth (Tutor2u Limited, 2003).

The basis of human capital theory is rooted in the work of Theodore Schultz, who produced his ideas in the early 1960s to explain the advantages of investing in education to improve agricultural output. The logical extension was to expand this correlation between better education and improved productivity across the entire economy. Schultz suggested that the yield on human capital in the United States was larger than that derived from physical capital such as new plant and machinery. Gary Becker, the 1992 Nobel Prize winner in economics, supported this idea, explaining that expenditure on education, training, and medical care could all be considered investments in human capital. "They are called human capital," he stated, "because people cannot be separated from their knowledge, skills, health or values in the way they can be separated from their financial and physical assets" (Tutor2u Limited, 2003).