1 Economics of Ideas ECON 401: Growth Theory

2 Economics of Ideas Studies neoclassical models model accumulation of physical and human capital they do not generate economic growth in the absence of technological progress Although technology is central, it was left unmodeled. It was exogenous to the model. What is technology? In economics, technology is the way inputs to the production process are transformed into output.

3 Economics of Ideas For example, in a general production function Y=F(K,L,.) tehnology is given by F(.). In a Cobb-Douglas production function, A is an index of technology. Ideas improve technology of production. A new idea leads to a higher prdoctivity of given inputs - a given bundle of inputs produce more or better output. In the context of production function, a new idea causes technology index to increase

4 Economics of Ideas Examples of ideas are many (not technological as well): Moore’s law asserts that the number of transistors that can be packed onto a computer chip doubles approximately every 18 months. In 1800, light was provided by candles and oil lamps. Not today. Nordhaus (1994) calculates that the price of light, adjusted by the quality, has fallen by a factor of 4000 since Wal-Mart approach to retailing Diet Soft drinks

5 Economics of Ideas The relationship between ideas and growth can be formalized as (by Paul Romer): Ideas ==>Nonrivalry ==> Increasing Returns => Imperfect Competition Ideas are nonrivalrous, implying the presence of increasing returns to scale. Increasing returns to scale implies imperfect competition. Most goods are rivalrous. That is, the use of one good by one person prevents others using the same good. - CD player - Attorney time - Attending growth class

6 Economics of Ideas Ideas, however, nonrivalrous. In other words, the use of one good does not prevent others using the same good. Once an idea has been created, anyone can take advantage of it. - computer chips - operating systems (apple, windows etc) Note that the paper the ideas are written on is rivalrous, an engineer is rivalrous, but the ideas are not. Ideas are partially excludable. - excudability indicates that the owner can charge a fee for its use

7 Economics of Ideas Figure 4.1 (from Romer (1993)) lists a variety of economic goods indicating the degree of excludability and whether they are rivalrous or not. Goods that suffer from “tragedy of commons” problem are rivalrous but have low degree of excludability. - grazing of commonland - restaurant bill - fishing Ideas are nonrivalrous, but the degree of excudability varies. Public goods are nonrivalrous goods that are essentially unexcludable. - national defense

8 Fig. 4.1

9 Economics of Ideas The economics of goods depends on their attributes: Goods that are excludable allow their producers to capture the benefits Goods that are not excludable involve substantial ‘spillovers’. Spillovers are benefits that are not captured by producers. Goods with positive spillovers tend to be underproduced (government intervention?) Basic R&D and national defense are some examples Goods with negative spillovers tend to be overproduced by the market (government regulation?) tragedy of commons Rivalrous goods must be produced each time they are sold Nonrivalrous goods need to be produced only once Fixed cost of production Marginal cost is zero (or close to zero) The only reason why marginal cost can be different from zero is that the nonrivalrous good is embodied in a rivalrous good.

10 Economics of Ideas Hence, economics of ideas is tied to presence of increasing returns to scale and imperfect competition. Ideas are associated with a fixed cost (link to IRS) Idea (for say next word processing with speech recognition) requires a one-time research cost Once we have the idea and the first product, each additional unit is produced with constant returns to scale In other words, we can view the production with a fixed cost and a constant marginal cost. Figure 4.2 plots production function y=f(x)=100*(x-F), where F is the fixed cost. This function exhibits constant marginal cost of production.

11 Fig. 4.2

12 Economics of Ideas Recall that a production function exhibits increasing returns to scale if f(ax)>af(x), where a>0. For the figure 4.2, 2F units of input will produce 100*F units of output – labor productivity (y/x) is increasing with the scale of the production. If MC is so low, why the prices of the products (say a computer software) are so high? Does it imply an inefficiency in the market? Yes, there is an inefficiency. - Remember efficiency requires price=marginal cost Presence of increasing returns implies that P=MC will lead to negative profits (Figure 4.3)

13 Fig. 4.3

14 Economics of Ideas With increasing returns to scale, average cost is always greater than marginal cost and hence marginal cost pricing results in negative profits.  No firm will enter this market and pay the fixed cost The production of new ideas requires the possibility of earning profits and therefore necessitates a move from perfect competition. How do we make sure the ideas will have some degree of excludability?

15 Economics of Ideas Patents and copyrights are legal mechanisms that grant inventors monopoly power. to reap a return from their inventions for a limited time period they are attempts to influence the degree of excludability of ideas (I.e., prevent reverse engineering)

16 Economics of Ideas World economic growth is a recent phenomenon. There is no good data going back before 1700 or So like Malthus, we can assume population and income are closely related. Figure 4.4 plots the average annual world population growth for the last 2000 years. this growth rate was % from 1 million B.C. to 1 A.D. From 1 A.D. to 1700, it was 0.075%. During the 18 th century and especially in the last forty years, it is nearly 2%.

17 Economics of Ideas How did the sustained economic growth started in the first place? According to economic historians, development of intellectual property rights is responsible for the modern economic growth. Establishment of long-lasting institutions allowed entrepreneurs to capture a positive rate of return from their innovations.

18 Fig. 4.4

19 Economics of Ideas What data do we have on ideas? It is not easy to measure the inputs to the production function and also outputs of the production function (the ideas themselves). R&D should be an important input Patent counts may produce a measure of ideas produced Drawback: many ideas are not patented (Coca-Cola) or produced using R&D resources (Wal-Mart operation manual) # of patents does not convey the economic value of the patents Figure 4.5 plots the number of patents awarded from 1880 to 1999.

20 Fig. 4.5

21 Economics of Ideas The number of ideas used in the US economy increased substantially over the century. Nearly half of all patents granted in 1999 were of foreign origin Most of the increase in patents over the last century reflects an increase in foreign patents Does this mean that the number of new ideas generated within US has been relatively constant? Probably not. Value of patents might be higher Not all ideas are patented Globalization of firms

22 Economics of Ideas Figure 4.6 plots the number of scientists and engineers engaged in R&D from 1950 to Not only the level of resources devoted to R&D has increased, but the share has also increased. The number of US scientists and engineers engaged in R&D increased from about 0.25% of the labor force in 1950 to around 0.75% in 1993.

23 Fig. 4.6

24 Economics of Ideas R&D expenditures in Turkey