Nobel Prize Citation
This year’s Prize in Economic Sciences rewards the design of methods that address some of the most fundamental and pressing issues of our time: long-run sustainable growth in the global economy and the welfare of the world’s population.
The study of how humanity copes with limited resources is at the heart of economics and, since its inception as a science, economics has recognised that the most important constraints on resources reflect nature and knowledge.
Nature dictates the conditions in which we live and knowledge defines our ability to manage these conditions. However, despite their central role, economists have generally not studied how nature and knowledge are affected by markets and economic behaviour. This year’s laureates, Paul M. Romer and William D. Nordhaus, have broadened the scope of economic analysis by designing the tools that are necessary to examine how the market economy has a long-term influence on nature and knowledge.
Knowledge For more than a century, the overall global economy has grown at a remarkable and fairly steady pace. When a few per cent of economic growth per year accumulates over decades and centuries, it transforms people’s lives. However, growth has progressed much more slowly throughout most of human history. It also varies from country to country. So what explains when and where growth occurs? Economics’ conventional answer is technological change, where the growing volumes of knowledge are embodied in technologies created by inventors, engineers, and scientists.
In the early 1980s, when he was a PhD student at the University of Chicago, Paul Romer started developing the theory of endogenous growth, where technological advances do not just flow in from external – exogenous – sources, as assumed in earlier economic models. Instead, they are created by purposeful activities in the marketplace. Romer’s findings allow us to better understand which market conditions favour the creation of new ideas for profitable technologies. His work helps us design institutions and policies that can enhance human prosperity by fostering the right conditions for technological development.
Technological innovation – Motivation
Long-term differences in growth rates have staggering consequences when they occur. If two economies start out with equal GDP per capita, but one grows at a 4 per cent higher rate, it will become almost five times richer in 40 years. A more modest 2 per cent growth advantage translates into twice as much national income in 40 years.
In the late 1980s, Romer observed that the income growth rates in actual data vary greatly from country to country. Figure 1, based one of Romer’s papers, depicts income per capita in 1960 and the average growth for the subsequent 25 years for over 100 countries; a graph with contemporary data looks virtually identical. Each square represents a country. As the figure shows, typical growth-rate differences between countries were several percentage points, and there is a huge gap – around ten percentage points – between the fastest and slowest growing countries. Moreover, the figure shows no systematic relationship between initial income and growth: some poor countries grow rapidly, while others actually shrink.
Romer concluded that understanding the causes of such persistent and ignificant growth-rate differences is crucially important, and started looking for an explanation.
Empirical and theoretical shortcomings As Romer noted, the dominant growth theory at the time – the Solow growth model, which received the Prize in Economic Sciences in 1987 – could explain many features of economic growth, but not large and persistent differences in growth rates. The Solow model predicts that poorer countries should grow faster and catch up with richer ones quite quickly, which is not what Figure 1 shows. In the model, an economy can grow by accumulating physical capital, for example machines or infrastructure, but capital-driven growth must peter out in the longer term; for any given technology, adding more capital yields less and less additional output. To allow for persistent long-run growth (and growth differences) in the model, the assumption has to be that, over time, labour becomes increasingly productive due to technological advances, although at varying rates for each country.
Therefore, the Solow model does not explain these trends, because changes in technology simply arrive exogenously from a “black box”.
A major breakthrough Romer’s biggest achievement was to open this black box and show how ideas for new goods and services – produced by new technologies – can be created in the market economy. He also demonstrated how such endogenous technological change can shape growth, and which policies are necessary for this process to work well. Romer’s contributions had a massive impact on the field of economics. His theoretical explanation laid the foundation for research on endogenous growth and the debates generated by his country-wise growth comparisons have ignited new and vibrant empirical research.
What’s special about ideas-driven growth? To answer that question, we must understand how ideas are different to goods such as physical or human capital. Romer taught us to think about goods using two dimensions, as in Figure 2.
In the first dimension, physical and human capital are rival goods. If a particular machine, or a trained engineer, is used in one factory, the same machine or engineer cannot be used at the same time in another factory.
Ideas, on the other hand, are non-rival goods: one person or firm using an idea does not preclude others from using it too. In the second dimension, these goods may be excludable if institutions or regulations make it possible to prevent someone from using them. For some ideas, such as results from basic research, this is difficult or even impossible – think about mathematical insights like the Pythagorean Theorem For other ideas, however, users can be excluded through technical measures (such as encryption) or patent laws. Romer’s breakthrough article showed how the rivalry and excludability of ideas determine economic growth.
Romer believed that a market model for idea creation must allow for the fact that the production of new goods, which are based on ideas, usually has rapidly declining costs: the first blueprint has a large fixed cost, but replication/reproduction has small marginal costs. Such a cost structure requires that firms charge a markup, i.e. setting the price above the marginal cost, so they recoup the initial fixed cost. Firms must therefore have some monopoly power, which is only possible for sufficiently excludable ideas.
Romer also showed that growth driven by the accumulation of ideas, unlike growth driven by the accumulation of physical capital, does not have to experience decreasing returns. In other words, ideas-driven growth can be sustained over time.
Market imperfections and policy
In principle, the new knowledge created by successful research and development, R&D, can benefit entrepreneurs and innovators anywhere in the world, now and in the future. However, markets generally do not fully reward the creators of new knowledge for the full benefits of their innovations, which means that – as long as the new knowledge is socially beneficial – too little R&D is conducted.
Furthermore, as market incentives for R&D come in the form of monopoly profits, there will typically be inadequate provision of new goods once they have been invented. Subsequent research has shown how market outcomes may also entail too much R&D – either when new ideas kill off too many existing firms in a process of creative destruction, or when new ideas augment socially harmful technologies, such as by enabling excessive extraction or use of fossil fuels, thus harming the climate.
To summarise, Romer showed that unregulated markets will produce technological change, but tend to underprovide R&D and the new goods created by it. Addressing this under-provision requires well-designed government interventions, such as R&D subsidies and patent regulation. His analysis says that such policies are vital to long-run growth, not just within a country but globally. It also provides guidelines for policy design: patent laws should strike the right balance between the motivation to create new ideas, by giving some monopoly rights to developers, and the ability of others to use them, by limiting these rights in time and space.
Extended Writeup by the Nobel Prize Foundation, Oct 2018
Bloomberg, Oct 2018
His work published in 1990 has served as the foundation for what’s called “endogenous growth theory,” a rich area of research into the regulations and policies that encourage new ideas and long-term prosperity.
Romer said he started investigating why economic growth was speeding up and came to realize in part it was due to the fact that more people were connected by technology. “Globalization is just not about trading stuff,” he said at a press conference in New York. “It’s about sharing ideas.”
QZ, Oct 2018
Romer said he hoped that the prize would spread the message that “people are capable of amazing things when we set about doing something.” Romer’s work centers on how the accumulation of ideas sustains growth, and how technology develops in a market economy.
Romer’s research has promoted so-called endogenous growth theory (pdf), which describes how investments in human capital, innovation, and knowledge are significant contributors to economic growth. Since the 1990s, Romer has demonstrated how economic forces govern the willingness of firms to produce new ideas that lead to breakthrough innovations.
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