New Growth Theory
reason: New Growth Theory divides the world into "ideas" and "things." What do you mean by that?
Romer: The paper that makes up the cup in the coffee shop is a thing. The insight that you could design small, medium, and large cups so that they all use the same size lid -- that's an idea. The critical difference is that only one person can use a given amount of paper. Ideas can be used by many people at the same time.
reason: What about human capital, the acquired skills and learned abilities that can increase productivity?
Romer: Human capital is comparable to a thing. You have skills as a writer, for example, and somebody -- reason -- can use those skills. That's not something that we can clone and replicate. The formula for an AIDS drug, that's something you could send over the Internet or put on paper, and then everybody in the world could have access to it.
This is a hard distinction for people to get used to, because there are so many tight interactions between human capital and ideas. For example, human capital is how we make ideas. It takes people, people's brains, inquisitive people, to go out and find ideas like new drugs for AIDS. Similarly, when we make human capital with kids in school, we use ideas like the Pythagorean theorem or the quadratic formula. So human capital makes ideas, and ideas help make human capital. But still, they're conceptually distinct.
reason: What do you see as the necessary preconditions for technological progress and economic growth?
Romer: One extremely important insight is that the process of technological discovery is supported by a unique set of institutions. Those are most productive when they're tightly coupled with the institutions of the market. The Soviet Union had very strong science in some fields, but it wasn't coupled with strong institutions in the market. The upshot was that the benefits of discovery were very limited for people living there. The wonder of the United States is that we've created institutions of science and institutions of the market. They're very different, but together they've generated fantastic benefits.
When we speak of institutions, economists mean more than just organizations. We mean conventions, even rules, about how things are done. The understanding which most sharply distinguishes science from the market has to do with property rights. In the market, the fundamental institution is the notion of private ownership, that an individual owns a piece of land or a body of water or a barrel of oil and that individual has almost unlimited scope to decide how that resource should be used.
In science we have a very different ethic. When somebody discovers something like the quadratic formula or the Pythagorean theorem, the convention in science is that he can't control that idea. He has to give it away. He publishes it. What's rewarded in science is dissemination of ideas. And the way we reward it is we give the most prestige and respect to those people who first publish an idea.
reason: Yet there is a mechanism in the market called patents and copyright, for quasi-property rights in ideas.
Romer: That's central to the theory. To the extent that you're using the market system to refine and bring ideas into practical application, we have to create some kind of control over the idea. That could be through patents. It could be through copyright. It might even be through secrecy. A firm can keep secret a lot of what it knows how to do.
reason: A formula for Coca-Cola?
Romer: Yes. Or take a lot of the things that Wal-Mart understands about discount retailing. They have a lot of insight about logistics and marketing which they haven't patented or copyrighted, yet they can still make more money on it than other people because they keep it closely held within the firm. So for relying on the market -- and we do have to rely on the market to develop a lot of ideas -- you have to have some mechanisms of control and some opportunities for people to make a profit developing those ideas.
But there are other stages in the development of ideas. Think about the basic science that led to the discovery of the structure of DNA. There are some kinds of ideas where, once those ideas are uncovered, you'd like to make them as broadly available as possible, so everybody in the world can put them to good use. There we find it efficient to give those ideas away for free and encourage everybody to use them. If you're going to be giving things away for free, you're going to have to find some system to finance them, and that's where government support typically comes in.
In the next century we're going to be moving back and forth, experimenting with where to draw the line between institutions of science and institutions of the market. People used to assign different types of problems to each institution. "Basic research" got government support; for "applied product development," we'd rely on the market. Over time, people have recognized that that's a pretty artificial distinction. What's becoming more clear is that it's actually the combined energies of those two sets of institutions, often working on the same problem, that lead to the best outcomes.
Romer: It traces back to this multiple use I was describing for ideas vs. single use for things. The miracle of the market system is that for objects, especially transformed objects, there's a single price which does two different jobs. It creates an incentive for somebody to produce the right amount of a good, and it allocates who it should go to. A farmer looks at the price of a bushel of wheat and decides whether to plant wheat or plant corn. The price helps motivate the production of wheat. On the other side, when a consumer has to decide whether to buy bread or corn meal, the price allocates the wheat between the different possible users. One price does both jobs, so you can just let the market system create the price and everything works wonderfully.
With ideas, you can't get one price to do both things. Let me give an extreme example. Oral rehydration therapy is one of those few ideas which did actually jump immediately from science to consumer benefit. It's a simple scientific insight about how you can save the life of a child who's suffering from diarrhea. Literally millions of lives have been saved with it. So what price should you charge people for using it?
Because everybody can use the idea at the same time, there's no tragedy of the commons in the intellectual sphere. There's no problem of overuse or overgrazing or overfishing an idea. If you give an idea away for free, you don't get any of the problems when you try and give objects away for free. So the efficient thing for society is to offer really big rewards for some scientist who discovers an oral rehydration therapy. But then as soon as we discover it, we give the idea away for free to everybody throughout the world and explain "Just use this little mixture of basically sugar and salt, put it in water, and feed that to a kid who's got diarrhea because if you give them pure water you'll kill them." So with ideas, you have this tension: You want high prices to motivate discovery, but you want low prices to achieve efficient widespread use. You can't with a single price achieve both, so if you push things into the market, you try to compromise between those two, and it's often an unhappy compromise.
The government doesn't pay drug companies prizes for coming up with AIDS drugs. It says they've got to incur these huge expenses, but then if they succeed, they can charge a high price for selling that drug. This has generated a lot of progress and we're prolonging the life of people with AIDS, but the high price is also denying many people access to those drugs.
Economic growth occurs whenever people take resources and rearrange them in ways that are more valuable. A useful metaphor for production in an economy comes from the kitchen. To create valuable final products, we mix inexpensive ingredients together according to a recipe. The cooking one can do is limited by the supply of ingredients, and most cooking in the economy produces undesirable side effects. If economic growth could be achieved only by doing more and more of the same kind of cooking, we would eventually run out of raw materials and suffer from unacceptable levels of pollution and nuisance. Human history teaches us, however, that economic growth springs from better recipes, not just from more cooking. New recipes generally produce fewer unpleasant side effects and generate more economic value per unit of raw material.
Take one small example. In most coffee shops, you can now use the same size lid for small, medium, and large cups of coffee. That wasn't true as recently as 1995. That small change in the geometry of the cups means that a coffee shop can serve customers at lower cost. Store owners need to manage the inventory for only one type of lid. Employees can replenish supplies more quickly throughout the day. Customers can get their coffee just a bit faster. Such big discoveries as the transistor, antibiotics, and the electric motor attract most of the attention, but it takes millions of little discoveries like the new design for the cup and lid to double average income in a nation.
Every generation has perceived the limits to growth that finite resources and undesirable side effects would pose if no new recipes or ideas were discovered. And every generation has underestimated the potential for finding new recipes and ideas. We consistently fail to grasp how many ideas remain to be discovered. The difficulty is the same one we have with compounding: possibilities do not merely add up; they multiply.
Thinking about ideas and recipes changes how one thinks about economic policy (and cows). A traditional explanation for the persistent poverty of many less developed countries is that they lack objects such as natural resources or capital goods. But Taiwan stared with little of either and still grew rapidly. Something else must be involved. Increasingly, emphasis is shifting to the notion that it is ideas, not objects, that poor countries lack. The knowledge needed to provide citizens of the poorest countries with a vastly improved standard of living already exists in the advanced countries. If a poor nation invests in education and does not destroy the incentives for its citizens to acquire ideas from the rest of the world, it can rapidly take advantage of the publicly available part of the worldwide stock of knowledge. If, in addition, it offers incentives for privately held ideas to be put to use within its borders - for example, by protecting foreign patents, copyrights, and licenses, by permitting direct investment by foreign firms, by protecting property rights, and by avoiding heavy regulation and high marginal tax rates - its citizens can soon work in state-of-the-art productive activities.
Some ideas such as insights about public health are rapidly adopted by less developed countries. As a result, life expectancy in poor countries is catching up with the leaders faster than income per capita. Yet governments in poor countries continue to impede the flow of many other kinds of ideas, especially those with commercial value. Automobile producers in North America clearly recognize that they can learn from ideas developed in the rest of the world. But for decades, car firms in India operated in a government-created protective time warp. The Hillman and Austin cars produced in England in the 1950s continued to roll off production lines in India through the 1980s. After independence, India's commitment to closing itself off and striving for self-sufficiency was as strong as Taiwan's commitment to acquiring foreign ideas and participating fully in world markets. The outcomes - grinding poverty in India and opulence in Taiwan - could hardly be more disparate.
For a poor country like India, enormous increases in standards of living can be achieved merely by letting in the ideas held by companies from industrialized nations. With a series of economic reforms that started in the early 1990s, India has begun to open itself up to these opportunities. For some of its citizens such as the software developers who now work for firms located in the rest of the world, these improvements in standards of living have become a reality. This same type of opening up is causing a spectacular transformation of life in China. Its growth in the last 25 years of the twentieth century was driven to a very large extent by foreign investment by multinational firms.
Leading countries like the United States, Canada, and the members of the European Union cannot stay ahead merely by adopting ideas developed elsewhere. They must offer strong incentives for discovering new ideas at home, and this is not easy to do. The same characteristic that makes an idea so valuable - everybody can use it at the same time - also means that it is hard to earn an appropriate rate of return on investments in ideas. The many people who benefit from a new idea can too easily free-ride on the efforts of others.
Idea gaps and object gaps in economic development (Journal of Monetary Economics 32 (1993) 543-573)
There is nothing new about the assertion that ideas and objects both contribute to the creation of wealth. Adam Smith emphasized that it is the objects like land and tools that constitute the true wealth of a nation, not monetary tokens, but even Smith recognized that these objects are of no inherent value as inputs without knowledge of how to combine them in ways that generate valuable output. Economists have used different terms to describe the activities that increased the stock of intangible knowledge or ideas – invention, innovation, discovery, technological change, entrepreneurship – but they have always acknowledged their fundamental importance.
Yet over time, economists relied increasingly on mathematics as the language of intellectual discourse. As they did, objects took precedence over ideas for purely technical reasons. Objects lend themselves readily to analysis in terms of convex opportunity sets and price-taking competition. This lets all of the mathematical machinery of convex optimization come into play, including the suggestive duality between quantities and shadow prices. Ideas, in contrast, are inherently associated with fixed costs or nonconvexities, and are therefore inconsistent with price-taking. Ideas — like Adam Smith's closely related notion of specialization and the division of labor – were pushed aside as the mathematical assumption of convexity and the behavioral assumption of price-taking took on greater importance in economic reasoning.
In Marshallian analysis at the level of firm or industry, it was possible to consider both the price-taking behavior of a competitive firm and the price-setting behavior of a monopolist. But when economists in general, and macro-economists in particular, pushed formal modeling to the level of a general equilibrium in the economy as a whole, there was no way to maintain this symmetry. Until the middle of the 1970s, economists could give a mathematical description of an entire economy only if they assumed that markets were characterized by perfect competition. There were some tentative early attempts to describe an aggregate equilibrium in which monopoly power was present [most notably by Joan Robinson (1933) and Edward Chamberlain (1933)]. Most economists, however, accepted the challenge of trying first to formalize existing intuitions in terms of perfectly competitive general `equilibrium models.
In the three decades following WWII, the mathematical program for the economics profession laid out in Paul Samuelson's Foundations of Economic Analysis came into full fruition. Some areas of aggregate economic analysis were set aside and subjected to an entirely different form of analysis (most notably the Keynesian analysis of demand-driven output determination), but in most areas of aggregative or economy-wide analysis, perfect, price-taking competition reigned supreme.
With the subsequent application of computable, aggregate models of perfect competition to questions in areas such as economic history, development planning, and tax policy, and with the development of the modern theory of efficient financial markets, price-taking models of perfect competition invaded virtually all of the important areas in aggregate theory. In the 1980s, real business cycle theory brought the last major holdout, macroeconomic fluctuations, under the domain of general equilibrium theory with perfect competition and price-taking. Along the way, ideas receded farther into the background in aggregate models because their intrinsic nonconvexities were inimical to an analysis in terms of price-taking. As the microeconomic analysis of patents makes clear, any economic model of the production and use of ideas must allow for monopoly power.
Economists continued to recognize the importance of invention and discovery, but in a competitive model, it could be discussed only if it was an exogenous force that impinged on the economy from the outside. The development of growth theory after Solow's influential papers (1956, 1957) is illustrative. No one really thought that technological change was exogenous. Everyone presumably expected that this provisional assumption, made only for analytical convenience, would subsequently be abandoned in a second round of theorizing. Yet, despite a variety of early theoretical efforts at understanding technological change at the aggregate level [Arrow (1962), Nordhaus (1969), Shell (1967)] and despite a body of microeconomic empirical and theoretical work on technological change that is far too large to begin to catalog here, aggregate growth theory stayed close to the formulation adopted by Solow. As a result, a whole generation of macroeconomists came to view exogenous technological change less as a provisional theoretical crutch and more as an acceptable description of how the world actually works.
In the development of formal economic theory, it was inevitable that competitive equilibrium theory would be developed before other more complicated notions of aggregate equilibrium could be worked out. A great deal of useful insight emerged from this work. One of the most important illustrations of the surprising power of competitive equilibrium theory came in labor economics with the development of human capital theory. To restate their case in the simplest and most explicit terms, economists like Gary Becker (1975) showed that human capital could be understood in exactly the same way that we understand the canine capital of a seeing-eye dog. Production of a more valuable worker or dog is just like the kind of production that takes place when a press bends metal. In each case, costly resources are invested to make a durable object (the sheet of steel or the brain of the person or dog) a more valuable input in production. Because slavery is not allowed, we use rental contracts and rental rates for human capital instead of the sale prices and contracts used for canine capital and steel, but the basic elements of competitive analysis are the same.
Technically, human capital theory was an analytical success precisely because it could be studied using the economic tools developed for objects. In particular, it did not require any discussion of monopoly power. As a result, developments in this area could not be used to help us model ideas. Nevertheless, our everyday experience with education, the most important investment activity in human capital theory, suggested that human capital was somehow connected to ideas. By embracing human capital theory, augmented perhaps by some notion of incomplete property rights and spillovers, one might have hoped that economic analysis could somehow get closer to capturing the elusive role of ideas in economic production. A fundamental claim of this paper is that this hope was largely mistaken.
As important as human capital theory is as an extension of the economics of objects, it does not capture the essential aspects of the economics of ideas. Human capital theory gets it right when it explains why the writer with no experience with word processing software faces large costs in learning to type a manuscript. It also gives us the correct framework for thinking about the equilibrium rental price for the time of someone who knows how to use word processing software and who sells his services on the market. But it entirely misses the complexity of the economic analysis of the production and sale of file recovery software or the production and exploitation of the kind of knowledge that lets Frito-Lay keep the right quantity of food on the shelves of thousands of geographically dispersed stores.
New goods, old theory, and the welfare costs of trade restrictions (Journal of Development Economics, Elsevier, vol. 43(1), S. 17ff)
"Arthur Lovejoy (1933) labeled the principle of plenitude. [For a discussion of the economic implications of this principle, see Warsh (1984).] This principle states that the world is full: every conceivable entity already exists. As a corollary, it follows that nothing truly new can ever come into being. Every conceptual possibility already has a realization in the physical world. To an economist, it means that we can always assume that we are in the interior of the goods space.
As Lovejoy shows, the principle of plenitude is fully formed in the writings of Plato and has played a central role in Western thought ever since, appearing prominently, for example, in the writings of Spinoza and Leibniz. The set of all conceivables entities corresponds to Plato's world of ideals. For every ideal there must exist a corresponding entity in the world of experience, for otherwise the world would be incomplete and imperfect.
Much of the thrust of modern scientific inquiry has been directed at overcoming our innate prejudice in favor of predetermination and plenitude. Many educated people are contemptuous of creationists who claim that there is a supreme being that created all existing forms of life according to a master plan and who deny the possibility that different forms of life emerged by chance and will continue to do so. We also ridicule the turn of the century head of the patent office who recommended the abolition of the patent system because everything had already been invented. Yet in their everyday approach to economic problems, most economists adopt a modeling strategy that reflects an implicit belief closely related to that of the patent clerk and the creationist.
The durability of the principle of plenitude can presumably be traced to a deeply rooted human desire to understand the world and therefore to believe that the world is capable of being understood. If we admit that new things can happen — that there are many things that could exist that do not yet exist — we undermine our most common explanation of why the world is the way it is: It has to be this way for it could not have turned out otherwise. For example, if there is only one conceivable form of intelligent animal, then we can explain why humans had to emerge from evolution in precisely the form that they did. People simply could not have turned out differently.
When it is applied in a specific context such as evolution, it is now obvious that the principle of plenitude is not just false; it is wildly misleading. The fossil record shows us that there are many conceivable types of animals that once existed but no longer exist. There are an extraordinarily large number of types of forms of life that could have evolved but did not because of a variety of historical accidents. If the earth had not been hit by the meteor that killed the dinosaurs, the forms of life on earth today would be different in ways that we can hardly begin to imagine. Scientifically, a far better guiding principle would be that of sparsity: only a vanishingly small fraction of all conceivable entities can actually exist in the physical world.
When we are confronted with things we do not understand, we all retreat into a world view that has more in common with the creationists than we would like to admit. Take cosmology. Implicitly, most of us believe that there is only one kind of physical universe that is conceivable. We can therefore explain (in some limited sense) why the universe is the way it is. It could not have turned out otherwise. For example, space must have three dimensions instead of . two or four because, we assert, there is no such thing as two or four dimensional real space, even in principle. As unsatisfying as this style of explanation may be, most of us find it preferable to the alternative. It is deeply unsettling to admit that humans, other animals, our planet, even the universe itself, are merely the result of a long sequence of accidents that determined which of many different conceivable outcomes were actually realized.
Modern cosmology suggests our universe itself is new. At some date there was a big bang when both space and time as we know them came into existence. And as if this were not enough, some physicists are now seriously raising the possibility that it was only our particular universe that was created in what we refer to as `the' big bang. This extension of the inflation model of big bangs suggests that our universe emerged from a small local fluctuation in the energy density in some prior universe, and that many comparable universes are continually branching off from our own and many other universes, expanding in their own big bang. Because these other universes start from slightly different initial conditions, the physical laws that they obey may be radically different from our own.
We would prefer to believe that there is only one kind of universe and that any universe could not possibly have turned out differently from the one we inhabit. But to theoretical physicists, the humorous physics exam question, `Define universe and give two examples', is starting to look serious. Perhaps the fact that space in our universe is three dimensional is an accidental outcome that is no more explicable than the fact that there are no mammals that lay eggs and fly.
The principle of plenitude manifests itself in the everyday operation of economic analysis in the implicit assumption that nevertheless, all the relevant goods already exist. It lets us think of economic analysis as taking place in the interior of goods space. It lets us tell our students that the essential economic problem is depicted in fig. 1, not fig. 3. Economists do recognize that the set of traded goods in an economy is always changing, but according to the economic version of plenitude, this turbulence is an epiphenomenon of no fundamental interest. According to this view, you can change the labels on a box of detergent, but detergent is just detergent. According to this view, all decisions in private markets can accurately be characterized as being like changes in the allocations of the quantities of a fixed and unvarying set of underlying goods that cover all of the relevant possibilities. Perhaps the clearest statement of this point of view comes in the characteristics space descriptions of goods articulated by Lancaster (1966). All apparently new goods are just different bundles of a fixed underlying set of primitive goods.
Economists have not always gone this far. Schumpeter was quite explicit about the central importance of the creation of genuinely new goods (1934). So was Young (1928). Yet in our post-WWII enthusiasm for distilling the `miracle of the market' down to its mathematical essence, economists have generally been willing to push these issues aside. Decentralized markets could be shown to get everything right only by assuming that half of our basic economic problem (and by far more difficult half at that) had already been solved. In the Arrow—Debreu world, all the relevant or useful dated and state-contingent goods have already been selected from the large set consisting of all possible goods. The only problem that remained for the economic system to solve was to allocate existing goods between a fixed set of existing uses."