Term Paper: Economics of New Ideas

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[. . .] These days, more and more economists are questioning what sparks growth. Many of these new economists base their ideas on those of Joseph A. Schumpeter, an Austrian economist and Harvard University professor (Farrell, 1994). Like Schumpeter, these economists are concentrating on technology, innovation, and knowledge. "The one fact that comes from economic history is the ability of the human mind to break through barriers that weren't imaginable 50 years ago." says Joel Mokyr, economic historian at Northwestern University (Farrell, 1994).

In the past, mainstream economics have struggled with the question of what determines long-term growth. In the late 1950s, Nobel laureate Robert M. Solow of Massachusetts Institute of Technology suggested that increases in the economy's labor supply and capital stock only partially explained economic growth. He attributed the rest to technological change, but was unable to describe why.

The Schumpeterians take traditional economics to a new level, examining the driving factors of technological change (Farrell, 1994). These economists are concerned with how growth is changed by the support for technical innovation, educational institutions, and rewards to entrepreneurs for new ideas. A leading Schumpeterian is Paul Romer of the University of California at Berkeley.

Romer's Ideas of Economic Growth

According to Paul Romer, an economist at the University of California at Berkeley, new ideas, embedded in technological change, drive economic growth and enable us to escape the grim future economists often predict is in store for us (Kelly, 1996). The world, in Romer's eyes, is not defined by scarcity and limits on growth, but rather is a world filled with endless opportunity, where new ideas produce new products, new markets, and new possibilities to create wealth. "Old growth theory says we have to decide how to allocate scarce resources among alternative uses," stated Romer (Kelly, 1996). "New growth theory says, 'Bull*****!' We're in this world, it's got some objects, sure, but it's got these ideas, too, and all that stuff about scarcity and price systems is just wrong.'"

Romer was first recognized in the economics field in 1986, with the first in a series of innovative papers that revived the study of economic growth, which had been declining for decades. "Paul single-handedly turned it into a hot subject," according to MIT economist and Nobel laureate Robert Solow (Kelly, 1996). During the 1950s, economists had developed some simple models and concluded that technological change accounted for approximately 80% of economic growth. However, these economists failed to specify just what technology meant, and the model did not describe how to figure it out or encourage its development.

These early economists were more concerned with preventing another depression, so they did not concentrate on technology. Instead, they focused on preventing inflation and unemployment from overwhelming the economy. Still, as the Great Depression faded into history, economics students sought new challenges. Romer, who studied physics in college but passed up law school to concentrate on economics, became curious about what exactly drives economic growth.

For many years, mainstream economists expected growth in the industrialized countries to decline or at least stay the same. Anticipating diminishing returns - the idea that the growth provided by adding another farm, factory, or employee declines over time - economists predicted that the growth would end some day. However, the economy continuously defied the expectations of these economists, causing many people to doubt the validity of their predictions.

By the time Romer began studying economics, new economies to the East, led by Japan, were explosive. According to Romer: "I looked at the problem and said, 'This theory doesn't have any clothes on,' and proceeded to start work on it (Kelly, 1996)."

Romer's main contribution to economics is the construction of a model that exposes the important role ideas play in driving growth. Like many economists, Romer starts his project by dividing the world into two parts - physical objects and ideas. According to Romer, objects include everything around us, from large steel mills to carbon and oxygen atoms. Alone, these objects are scarce and subject to the law of diminishing returns. Thus, they are unable to drive economic growth. However, ideas can. Human beings, Romer believes, have a nearly infinite capacity to reconfigure physical objects by creating new ideas for their use. New ideas on how to increase, for example, the power of a hard drive, enable people to boost productivity, develop new opportunities for profit, and ultimately drive economic growth.

The best thing about ideas, according to Romer, is that they are nearly endless. "On the ideas side you have combinatorial explosion," he says (Kelly, 1996). "There's essentially no scarcity to deal with." For example, the number of possible bitstreams that can be turned into a CD-ROM comes to something in the range of 10 to the power of 1 billion, virtually ensuring that people will always find new software. "There isn't enough mass in the universe to make that number of CDs," he says.

Therefore, Romer believes that because the number of ways to rearrange an object and to create something of greater value is so vast, the prospects for economic growth are far greater than economists of the past even imagined.

To prove his point, Romer discusses a brainteaser (Kelly, 1996). Using chemical reactions, humans can reorder carbon and hydrogen into structures like new polymers and proteins. To test just how far this process can go, Romer imagines the chemical refinery of the future, which would be small and mobile enough to search out its own inputs, capable of maintaining a constant temperature, self-healing, and able to replace itself - all without human intervention.

However, Romer points out that this refinery already exists -- the milk cow (Kelly, 1996). He uses this example to show that if hundreds of millions of years of evolution can produce the milk cow, there must be an endless number of ideas for combining atoms that have not been discovered yet. For example, scientists are already changing the DNA of cattle, attempting to produce cows that secrete lactoserrin into their milk. Thus, the world has not even touched the surface of the infinite ideas that could change the economy.

Economically, new technologies like biotechnology help diminish the old image of diminishing returns. For this reason, traditional economists believe that growth has its limits. However, it seems that these new technologies create increasing returns, because new ideas, which generate new products, is generated through research. There is another benefit from increasing returns -- declining costs. A new idea that spawns a new product can make it easier and cheaper to produce new units. For example, including research costs, the first copy of Windows NT may have cost Microsoft $150 million. However, each copy produced after that was basically free.

According to Kelly (1996), "Early software pirates understood this property of software intuitively when they passed copies of WordPerfect or Lotus among friends. The reasoning was, why pay for something when it cost the company barely anything to produce? Here's where Romer ultimately runs afoul of classical theory. Old-school economics assumes that companies charge for a product exactly what it cost to manufacture or harvest the last unit. If that were the case, software firms would hand out their goods on every street corner."

However, when industries have high research costs and low production costs, they tend to lean toward a monopoly, which is best described as a situation in which companies charge more for their goods than what it cost to produce the last unit. "If you forced anyone in the world of ideas to sell their product at the cost of producing the last unit, they'd go bankrupt," says Romer.

According to traditional economists, monopolies are not supposed to occur, as competition is assumed to be perfect, meaning that many small firms compete against each other, but none is able to set prices; the cost of entry into the market is nothing; and prices reflect the cost of production.

However, when it comes to technology, this way of thinking is obsolete. Because the cost of research is so high, the price of market entry can be very high. As a result, large firms engage in brutal competition, and by simultaneously funding new discoveries while paying for old ones, they charge much more than the cost of production. The economics of monopolistic competition is the economics of today's technology age.

According to Kelly (1996), "But there's a big conundrum for monopolies and monopolistic societies. What price is the right price to charge for a new idea, for a new software tool? The classical notion of price-setting worked well. More often than not, demand equaled supply; and competition kept suppliers from charging more than consumers would pay. This classical understanding of pricing provided the ideological cover for market economies to flourish. For more… [END OF PREVIEW]

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