Following on from yesterday, I thought I’d give a one-paragraph summary of how economics tends to think about long-term, or steady-state, growth. I say long-term because the Solow growth model does a remarkable job of explaining medium-term growth through the accumulation of factor inputs like capital. Just ask Alwyn Young.
In the long run, economic growth is about innovation. Think of ideas as intermediate goods. All intermediate goods get combined to produce the final good. Innovation can be the invention of a new intermediate good or the improvement in the quality of an existing one. Profits to the innovator come from a monopoly in producing their intermediate good. The monopoly might be permanent, for a fixed and known period or for a stochastic period of time. Intellectual property laws are assumed to be costless and perfect in their enforcement. The cost of innovation is a function of the number of existing intermediate goods (i.e. the number of existing ideas). Dynamic equilibrium comes when the expected present discounted value of holding the monopoly equals the cost of innovation: if the E[PDV] is higher than the cost of innovation, money flows into innovation and visa versa. Continual steady-state growth ensues.
It’s by no means a perfect story. Here are four of my currently favourite short-comings:
- The models have no real clue on how to represent the cost of innovation. It’s commonly believed that the cost of innovation must increase, even in real terms, the more we innovate – a sort of “fishing out” effect – but we lack anything more finessed than that.
- I’m not aware of anything that tries to model the emergence of ground-breaking discoveries that change the way that the economy works (flight, computers) rather than simply new types of product (iPhone) or improved versions of existing products (iPhone 3G). In essence, it seems important to me that a model of growth include the concept of infrastructure.
- I’m also not aware of anything that looks seriously at network effects in either the innovation process (Berkley + Stanford + Silicon Valley = innovation) or in the adoption of new stuff. The idea of increasing returns to scale and economic geography has been explored extensively by the latest recipient of the Nobel prize for economics (the key paper is here), but I’m not sure that it has been incorporated into formal models of growth.
- Finally, I again don’t know of anything that looks at how the institutional framework affects the innovation process itself (except by determining the length of the monopoly). For example, I am unaware of any work emphasising the trade-off between promoting innovation through intellectual property rights and hampering innovation through the tragedy of the anticommons.