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11.15 Endogenous Growth: The Economics of Ideas

The issue of convergence has raised as an important question the possible

importance of differences in technology (knowledge) across the economies

of the world. The Solow model attempts to explain per capita income level

and growth differences assuming that technology is a pure public good and is

therefore freely available to all countries irrespective of their level of development.

An increasing number of economists, and most economic historians

and development economists see significant technology gaps as the crucial

problem facing poor countries. Such an approach emphasizes the need for

policies to be adopted that will close ‘idea gaps’ between nations (P. Romer,


Paul Romer’s 1986 model explains technological progress as an unintentional

by-product of capital accumulation by individual firms. Subsequently,

Romer (1990), dissatisfied with his initial approach, proceeded to develop a

second strand of new growth theory. Endogenous innovation models embrace

a neo-Schumpeterian framework of endogenous technological change based

on three premises (Grossman and Helpman, 1991, 1994; Crafts, 1996; Aghion

and Howitt, 1998). First, as in the Solow model, the basic driving force

behind economic growth is technological change, that is, improvements in

knowledge about how we transform inputs into outputs in the production

process. Second, technological change is endogenous, being determined by

the deliberate activities of economic agents acting largely in response to

financial incentives. Third, the defining characteristic of ideas/knowledge is

that ‘once the cost of creating a new set of instructions has been incurred, the

instructions can be used over and over again at no additional cost’ (Romer,

1990). Therefore ideas are non-rivalrous outputs and their use by one firm or

person does not in any way reduce their availability to other firms or persons.

Ideas are also ‘partially excludable’, where excludability is defined as the

ability of the owners of a good to prevent other economic agents from using it

without payment. As Romer (1990) notes, ‘excludability is a function of the

technology and the legal system’. Given Romer’s second premise that technological

change results from the purposeful actions of self-interested

economic agents, improvements in technology (new ideas) must generate

benefits to individuals that are at least ‘partially excludable’, for example by

having patent laws.

Romer’s insights have led to a burgeoning of research into the economics

of ideas (Jones, 2002, 2005). The three premises discussed above have two

important implications for the theory of economic growth. First, because

ideas are non-rivalrous, they can be accumulated without limit on a per capita

basis. Second, because of incomplete excludability (appropriability), knowledge

creation involves substantial spillovers of benefits (externalities) which

cannot be entirely captured by the economic agents who produce the ideas.

The ‘unbounded’ growth and ‘incomplete appropriability’ features of the

economics of ideas imply that ‘output cannot be a constant-returns-to-scale

function of all its inputs taken together’. Romer’s analysis implies increasing

returns to scale and by implication microfoundations based on the presence

of imperfect competition (see Romer, 1994a).

While a non-rivalrous good such as a new idea involves a fixed cost of

production, which is often substantial, once the new knowledge has been

created there is zero marginal cost involved with any further use of the new

idea. A new design is costly to produce but once in existence it can be used as

often as desired and in as many contexts as desired. It is for this reason that

legal mechanisms such as patents and copyrights exist in order to grant

investors monopoly rights over a new idea, at least for a time, so that they can

earn a reward for their new ideas (Kremer, 1998; Mazzoleni and Nelson,

1998). The importance of this issue has been illustrated by North (1990), who

argues that the economic development of Western Europe did not seriously

begin until the development of property rights ensured that individuals could

reap some of the benefits of their ‘ideas’ and helped to speed up the pace of

technological change (Crafts, 1995). The era of modern economic growth,

beginning with the Industrial Revolution in Britain,

occurred when the institutions protecting intellectual property rights were

sufficiently well developed that entrepreneurs could capture as a private return

some of the enormous social returns their innovations would create … history

suggests that it is only when the market incentives were sufficient that widespread

innovation and growth took hold. (Jones, 2001a)

In the case of the USA the framers of the US Constitution were eager to

‘promote the progress of science and useful arts’. Therefore an intellectual

property clause providing for copyright and patent rights appears in the first

article of the Constitution and by 1810 the USA ‘far surpassed Britain in

patenting per capita’ (Khan and Sokoloff, 2001). The failure of China to lead

the first Industrial Revolution has also been attributed to that country’s inability

to establish a free market, institutionalize property rights, provide an

environment conducive to emulation and innovation, and to absorb foreign

technology (Landes, 1998). Thus according to the new breed of endogenous

growth models, ‘the government has great potential for good or ill through its

influence on the long-term rate of growth’ (Barro, 1997). Economic growth

can be influenced not only by policies that affect trade regimes, technology

transfer, the provision of infrastructure and financial markets, but also by

policies that affect taxation and incentives, the protection of intellectual

property rights and the maintenance of law and order.

By developing an endogenous theory of technological change Romer has

challenged both the traditional and augmented versions of the Solow neoclassical

growth model (see below, section 11.16). In the neoclassical model

technology is assumed to be exogenous and hence available without limitation

everywhere across the globe. Romer (1995) rejects this assumption on

the basis of ‘overwhelming evidence’ that technology is not a pure public

good. The neoclassical model emphasizes ‘object gaps’, differences in physical

and human capital, in explaining income per capita differentials across

nations. While Mankiw (1995) believes that much of the variation in living

standards can be explained by differences in the quantities of human and

physical capital, in contrast Romer (1993) emphasizes ‘idea gaps’, productivity

differences resulting from technology gaps, as the main source of divergent

living standards.

Parente and Prescott (1994, 1999, 2000) also attribute differences in international

incomes to technology gaps. In their research they have found evidence

to suggest that these productivity gaps are not caused by fundamental differences

in the stock of available knowledge that developing countries have

access to. Instead, Parente and Prescott argue that there exist barriers in the

form of society-imposed constraints which prevent firms in many developing

countries from adopting better production methods, and many of these constraints

‘are put in place to protect the interests of groups vested in current

production processes’. As a result they conclude that most differences in

international incomes ‘are the result of differences in total factor productivity’.

Parente and Prescott (2005) conclude that ‘changes in a country’s

institutions that result in large increases in the efficiency with which resources

can be used in production give rise to growth miracles’.

Romer’s position has received recent support from the research of Easterly

and Levine (2001), who find that the ‘residual’ (total factor productivity)

rather than factor accumulation can explain most of the cross-country income

and growth differentials. Their data show that while factor accumulation is

persistent, growth is not. Nelson and Pack (1999), in their discussion of the

Asian miracle and modern growth theory, also stress the importance of the

entrepreneurship, innovation and learning that these economies had to undertake

before they could successfully assimilate new technologies. In their view

the accumulation of human and physical capital is a necessary but far from

sufficient part of this process. What is crucial for success is the establishment

of a policy environment that nurtures learning, and for economists to better

understand the learning process taking place during the assimilation of new

ideas and technologies they need ‘a better theory of firm behaviour in such


Historical experience demonstrates that the creation and transmission of

ideas has undoubtedly been an important determinant of current living standards

(Rosenberg, 1994; Mokyr, 2005). If Romer is correct and the poor

countries do suffer from idea gaps rather than object gaps, then a significant

part of worldwide poverty can be eliminated ‘at relatively low cost’ via

technological ‘catch-up’. A clear implication of this analysis is that nations

which isolate themselves from the free flow of ideas, or erect barriers to the

adoption of new technologies, will suffer relative stagnation since trade policies

and openness affect innovation and growth. Foreign direct investment

can act as a significant channel for the diffusion of new innovations and

ideas, thereby enhancing the growth process (Grossman and Helpman, 1990;

Romer, 1994b; Sachs and Warner, 1995; Proudman and Redding, 1997;

Edwards, 1998; Parente and Prescott, 2000). Therefore, at least potentially,

poor economies have the most to gain from reducing restrictions to international

trade, encouraging inward FDI flows and investing in human capital

because by doing so they can gain access to the stock of world knowledge

(World Bank, 1998/9). While in the neoclassical model the removal of inefficiencies

caused by trade barriers will produce level effects on production

possibilities but no sustained growth effects, in endogenous growth models

the growth effects of increasing economic integration are likely to be much

more important.

A further implication of Paul Romer’s research is that for the USA to

maintain its leadership position, government policies must continue to support

a high level of R&D activities in both private and public institutions.

Given the well-documented large divergence between social and private rates

of return from R&D expenditures, the government has a vital role to play in

preventing underinvestment in this activity. In a recent investigation of the

optimal rate of R&D investment in the USA Jones and Williams (1998)

conclude that the private rate of return to R&D in the USA is of the order of

7–14 per cent, while a ‘conservative estimate’ of the social rate of return is 30

per cent. Therefore Jones and Williams conclude that optimal R&D spending

as a share of GDP is ‘more than two to four times larger than actual spending’

(see also Jones and Williams, 2000).

In contrast to the supply-side view of the growth of knowledge, ideas and

technological change, Schmookler (1966) argues that technological change is

primarily demand-induced. Unlike Romer’s model, where a key input to the

development of new technology is the supply of previous innovations (see

Jones, 2005), Schmookler sees the stimulus to technological change and innovation

as the need to solve current technological problems; that is, technological

change is demand-driven and dependent on the usefulness of new ideas. In a

recent discussion of Schmookler’s work, Kelly (2002) concludes that the supply-

and demand-side influences on technology are complementary.

An important deficiency of recent endogenous growth theories is that they

lose the prediction of conditional convergence, a prediction which Barro

(1997) argues has a ‘strong empirical regularity in the data for countries and

regions’. To rectify this flaw Barro and Sala-i-Martin (1997) have developed

a model that combines elements of endogenous growth with the convergence

implications of the Solow model. Their model has the following elements:

1. in the long run the rate of growth in the world economy is driven by

technological discoveries in the leading economies;

2. follower economies share in the new innovations via a process of imitation;

3. since imitation is generally cheaper than innovation, ‘most countries

prefer to copy rather than invent’;

4. the relatively low cost of imitation implies that the follower economies

will grow relatively faster than the leader economies and converge, at

least part way, towards the leaders;

5. as the amount of uncopied innovations decreases, the costs of imitation

will tend to rise and therefore the follower’s growth rate will tend to slow


6. therefore, the Barro/Sala-i-Martin model generates a form of conditional

convergence based on the diffusion of technology across countries and

resembles the predictions of the Solow model;

7. in the long run ‘all economies grow at the rate of discovery in the leading


The Barro/Sala-i-Martin hybrid model therefore establishes a framework where

long-run growth is driven endogenously by the discovery of new ideas in the

‘leading-edge’ economies, but also retains the convergence properties of the

neoclassical growth model via the impact of the imitation behaviour of follower