"New" macroeconomics (3)

   In my last post for this series, I have introduced Paul Krugman's 1979 paper on international trade. This is perhaps the first paper that re-ignited economists' interest in increasing returns at the macroeconomic level. As scale economy can explain the prevalent trade pattern -- intra-industry trade -- better than traditional theory, one may start to wonder the world is more suitably described by models featuring increasing returns.
   The explanatory power of scale economy for macroeconomic phenomenon was soon confirmed by another theory innovation -- Paul Romer's endogenous growth theory or "new" growth theory.
   Why do we need a "new" growth theory? What is "endogenous" in this theory? This is related to what traditional growth theory says. Put it simply. Growth is either fueled by employing more inputs or by technology improvement, which means the same quantities of inputs can produce more. Broadly speaking, labour and capital are two major inputs for production. Empirically, most advanced countries' population growth, thus labour input growth, is stable at a low rate. Then, can growth be sustained by employing more capital (more investments)? If capital actually grows faster than labour, the law of diminishing marginal returns applies. As extra output is smaller and smaller, output growth will then be declining over time. Thus, investing too much is not a way to obtain a sustainable stable growth rate. In fact, capital growth and investment normally simply keeps the pace of labour.
   Now, if production exhibits constant returns to scale, and if both labour and capital grow at the same rate, output can only grow at the same rate. As output and labour move at the same pace, GDP per capita (or per worker) will stagnate. But that's also not realistic -- in the real world, almost all advanced countries record stable (though low) growth in GDP per capita. Living standard per person is indeed improving over time.
   Now, it is clear that, to explain the real-world growth pattern, one must resort to technology (or productivity) improvement. This is the major conclusion of traditional growth theory, or what may be called the Solow model as the theory is due to economist Robert Solow, who won the Nobel prize in 1987.
   While the theory is insightful, what Solow left unanswered is why technology may keep growing? Solow simply sets this question aside. As such, technology is an unexplained factor in his model, and thus an "exogenous" variable (in economics terminology). The task of "new" and "endogenous" growth theory is exactly to explain technology or productivity improvement.
   Why does technology improve over time? The answer is more or less the same as why capital grows: people invest in innovations that fuel technology improvements. Investors' behaviours are again explainable by cost and benefit involved in it. So, the "new" theory is simply applying these old theory to the new area -- the invention sector. But is it? If this is so, the above problem cannot be solved indeed. Normally diminishing marginal returns applies to any input-output relation. If innovation is a normal product, eventually its marginal returns will be declining, other things being equal. We cannot rescue the traditional growth theory simply by introducing a new investment activity subject also to the same pattern of diminishing marginal returns and constant returns to scale.
   At this point, we can see why increasing return is an important factor for growth. If investment in technology exhibits increasing returns, it can sustain a stable GDP per capita growth. But is there increasing return? In fact, there is a good reason why increasing return exists. Technology improvement is due to new ideas, which are knowledge and which are, in economics terminology, public goods. To obtain a new idea, we need investments. But once a new good idea is found, it can let as many people as possible make use of the idea without extra resource incurred. Increasing returns are then possible. But the situation is also not that simple because we need to explain why there are private investments in public goods. For a public good like an idea, if you cannot prevent others from enjoying the idea for free, there is no reason why you will devote efforts and resource to inventing it. Hence, the whole point is not public good but excludable public good: you can prevent others from enjoying it if they don't pay you; you can get the reward of invention although the good can be shared by many people without extra resource incurred. Patents and intellectual properties are a key element involved for making the invention business profitable. The idea can be shared but you have to pay for it first.
   Either we need a policy that can properly protect private property (invention) rights or we need an environment that can encourage (private or public) innovations. These are the key to sustainable economic growth in this "new" theory. Paul Romer's contribution is to re-discover these (perhaps old) concepts about public goods and increasing returns, relate them to growth, and construct appropriate mathematical models for the mechanism. For this contribution, he got the Nobel prize in economics in 2018.