The economics of long-run growth, in tech innovation and climate change

Sveriges Riksbank Prize in Economic Sciences in memory of Alfred Nobel: The two men awarded have been obsessed with economic growth and human welfare outcomes over decades, or even centuries.

Written by Harish Damodaran | New Delhi | Updated: October 9, 2018 7:58:22 am
The winners: William D Nordhaus (left) “for integrating climate change into long-run macroeconomic analysis”; Paul M Romer “for integrating technological innovations into long-run macroeconomic analysis

The Great Economists mostly studied long-run growth and its drivers. John Maynard Keynes was an exception, whose primary concern was the periodic fluctuations of employment, income and output and why businessmen weren’t interested in investing in the short run. “In the long run we are all dead,” he once declared. However, the vast majority — including the two men awarded the 2018 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (often described as the “Economics Nobel”) Thursday have been obsessed with economic growth and human welfare outcomes over decades, or even centuries.

Paul M Romer

Paul M Romer, a product of the University of Chicago and currently an economics professor at New York University’s Stern School of Business, is credited with laying the foundations of what is now called “endogenous growth theory”.

Robert M Solow, winner of the 1987 Economics Prize, was among the first to identify technological progress as the key determinant of growth in the long run. But the Solow model, even while showing how technological breakthroughs contributed to improvement in total factor productivity (the same amount of inputs producing more output), did not shed light on what determined advances in practical scientific knowledge itself. For Solow, technological innovation was “exogenous” to his model. It just happened and so long as it did, long-term growth in output and broad human welfare was guaranteed.

That’s where Romer comes in.

Thirty-four years after Solow published his 1956 paper ‘A Contribution to the Theory of Economic Growth’, the 35-year-old authored a journal article titled ‘Endogenous Technological Change’. According to Romer, far from being “exogenous”, technological change was “endogenous” and arising from “intentional investment decisions made by profit-maximising agents”. This was reminiscent of Karl Marx’s statement from The Poverty of Philosophy (1847): “The hand-mill gives you society with the feudal lord; the steam-mill society with the industrial capitalist”.

For Romer, technology or “ideas” as input in production is different from normal goods. It is “non-rival”: one person’s use of an idea (unlike labour or capital) does not preclude others from also using it. The success in generating new ideas — which is, of course, key to long-term growth — then depends on the extent to which they can be made “excludable”. Such excludability, whether through patent laws or technical protection via encryption, is critical for ideas to be produced in the marketplace. And it also explains why technological progress is best achieved in a capitalist society (as Marx probably reluctantly admitted) and is also endogenous to the workings of the system.

Since technology basically allows more to be produced from the same amount of input as used previously — what economists term “increasing returns to scale” —the developer-user is able to reap the rewards of innovation by selling his product at slightly lower prices than competitors, while still recouping his initial R&D investments. At the same time, the inherent non-rival character of productive ideas makes them naturally prone to sharing and generating “positive externalities” (ideas beget ideas, including by others). Every society at a given point has to decide how much of such spillover benefits to allow, and simultaneously provide limited monopoly, to ensure that an excess of social over private benefits does not result in underproduction of new ideas.

William D Nordhaus

The work of the second economist who has got the Prize this time — William D Nordhaus from Yale University — also deals with long-term growth. But unlike the Solow and Romer models, which did not factor in any limits or obstacles to growth and technological change was always associated with positive externalities, in Nordhaus’s work externalities are predominantly “negative”.

Growth possibilities are, to start with, limited by the finiteness of natural resources, Nordhaus actually wrote in a 1974 American Economic Review article ‘Resources as a Constraint on Growth’. Secondly, growth, to the extent it involves carbon-dioxide emissions contributing to global warming and climate change, can generate the greatest of negative externalities and market failures. In the case of positive externalities, the benefit to society from a good exceeds that for the individual producer. So, less gets produced than what is socially optimal. When externalities are negative, the effect is the opposite: Since burning of coal imposes costs on third parties (the environment), raising social costs over what the polluter alone incurs, it would encourage further burning. The only way to prevent this eventuality is by taxing polluters or rewarding those who don’t burn through carbon credits.

Nordhaus’s fundamental contribution is in “endogenising” climate change in long-term growth models. The quantitative Integrated Assessment Models or IAMs he developed in the mid-1990s helped simulate and evaluate different economic growth paths with their implications for climate. IAMs were used in the newly released report of the IPCC (Intergovernmental Panel on Climate Change).

“The IAMs constructed by Nordhaus — and others who followed in his footsteps — allow us to numerically compare different paths for future growth and well-being for different paths of policies,” the Royal Swedish Academy of Sciences said in its background note for this year’s Economic Sciences Prize.

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