New Growth Theory

The economic growth model Opens in new window we have been using was first developed in the 1950s by Robert Solow, a winner of the Nobel Prize in Economics Opens in new window. According to this model productivity growth is the key factor in explaining long-run growth Opens in new window in real GDP per capita.

In recent years some economists have become dissatisfied with this model because it does not explain the factors that determine productivity growth.

What has become known as the new growth theory (or endogenous growth theory) was developed by economist Paul Romer to provide a better explanation of the sources of productivity change.

New growth theory is a model of long-run economic growth that emphasizes that technological change is influenced by economic incentives, and so is determined by the working of the market system.

Romer argues that the rate of technological change Opens in new window is influenced by how individuals and firms respond to economic incentives Opens in new window.


Earlier accounts of economic growth left technological change unexplained or attributed it to factors such as chance scientific discoveries.

Romer opines that the accumulation of knowledge capital is a key determinant of economic growth. Firms contribute to an economy’s stock of knowledge capital when they engage in research and development or otherwise contribute to technological change.

Researches have shown that accumulation of physical capital is subject to diminishing returns: increases in capital per hour worked lead to increases in real GDP per hour worked, but at a decreasing rate.

Romer argues that the same is true of knowledge capital, at the firm level. As firms add to their stock of knowledge capital they will increase their outputs, but at a decreasing rate.

At the level of the entire economy rather than just individual firms, however, Romer argues that knowledge capital is subject to increasing returns.

Increasing returns can exist because knowledge, once discovered, become available to everyone. The use of physical capital, such as computer or machine factory, is rival because if one firm uses it other firms cannot, and excludable because the firm that owns the capital can keep other firms from using it.

The use of knowledge capital, such as the chemical formula for a drug that cures cancer, is non-rival, however, because one firm’s use of this knowledge does not prevent another firm from using it.

Knowledge capital is also non-excludable because, once something like a chemical formula becomes known, it becomes widely available for other firms to use (unless, as we will soon discuss, the government gives the firm that invents a new product the legal right to its exclusive use).

Because knowledge capital is non-rival and non-excludable, firms can free ride on the research and development of other firms.

Firms free ride when they benefit from the results of research and development they did not pay for.

For example, transistor technology was first developed at Western Electric’s Bell Laboratories in the 1950s and served as the basic technology of the information revolution.

Bell Laboratories, however, received only a tiny fraction of the immense profits that were eventually made by all the firms that used this technology.

Romer points out that firms are unlikely to invest in research and development up to the point where the marginal cost of the research equals the marginal return from the knowledge gained because much of the marginal return will be gained by other firms.

Therefore there is likely to be an inefficiently small amount of research and development, slowing the accumulation of knowledge capital and economic growth.

Government policy can help increase the accumulation of knowledge capital in three ways:

1.   Protecting intellectual property with patents and copyrights.

Governments can increase the incentive to engage in research and development by giving firms the exclusive rights to their discoveries for a period of years.

The Australian federal government, through its Department of Intellectual Property, Australia, grants patents to companies that develop new products or new ways of making existing products.

Patent is the exclusive right to produce a product for a period of time from the date the product was invented.

A standard patent gives a firm the exclusive legal right to produce a new product for a period of time (20 years in Australia) from the date the product was invented.

For example, a pharmaceutical firm that develops a drug can secure a patent on the drug, keeping other firms from manufacturing the drug without permission.

The profits earned during the period the patent is in force provide an incentive for undertaking the research and development.

The patent system has drawbacks, however. In filing for a patent, firms must disclose information about the product or process.

This information enters the public record and may help competing firms develop products or processes that are similar but that do not infringe on the patent. To avoid his problem some firms try to keep the results of their research a trade secret, without patenting it. A famous example of a trade secret is the formula for Coca-Cola.

Tension also arises between the government’s objectives of providing patent protection that give firms the incentive to engage in research and development and making sure that the knowledge gained by the research is widely disseminated for the greatest impact on the economy. Economists debate the characteristics of an ideal patent system.

Just as a new product or a new method of making a product receives patent protection, so books, movies, music and software receive copyright protection.

Copyright is the legal right of the creator of a book, movie, piece of music or software program to the exclusive right to use the creation during the creator’s lifetime, plus an additional period of time for their heirs.

The Australian Copyright Council awards the creator of a book, movie, piece of music or software program the exclusive right to use the creation during the creator’s lifetime.

If the creation was published before 2005 the creator’s heirs retain this exclusive right for 50 years after the creator’s death or 50 years from when the material was first published.

Following a change in copyright law, this period of time was extended to 70 years if the creation occurred after 1 January 2005.

2.   Subsidizing research and development.

The government can use subsidies to increase the quantity of research and development that takes place.

For example, the federal government’s National Health and Medical Research Council subsidizes research institutes and universities to carry out medical research.

The government also provides tax benefits to firms that invest in research and development.

3.   Subsidizing education.

People with technical training carry out research and development. If firms are unable to capture all the profits from research and development, the wages and salaries paid to technical workers will be reduced.

These lower wages and salaries reduce the incentive to workers to receive this training. If the government subsidizes education it can increase the number of workers with technical training.

In Australia the government subsidizes education by directly providing free education from kindergarten to Year 12, and by providing substantial support for Technical and Further Education (TAFE) colleges and universities.

The government also pays a portion of the full cost of student tertiary education fees and provides interest-free student loans, the repayments of which are indexed to inflation. Further, there is a range of schemes and subsidies for apprenticeships and on-the-job training.

These government policies can bring the accumulation of knowledge capital closer to the optimal level.