Home > The Economics Profession > Paul Romer’s & Paul Krugman’s dangerous idea

Paul Romer’s & Paul Krugman’s dangerous idea

from Lars Syll

If you have an apple and I have an apple and we exchange these apples then you and I will each have one apple.

But if you have an idea and I have an idea and we exchange these ideas, then each of us will have two ideas.

George Bernard Shaw

Adam Smith once wrote that a really good explanation is “practically seamless.” Is there any such theory within one of the most important fields of social sciences – economic growth?

In Paul Romer’s Endogenous Technological Change (1990) knowledge is made the most important driving force of growth. Knowledge (ideas) are presented as the locomotive of growth — but as Allyn Young, Piero Sraffa and others had shown already in the 1920s, knowledge is also something that has to do with increasing returns to scale and therefore not really compatible with neoclassical economics with its emphasis on decreasing returns to scale.

Increasing returns generated by non-rivalry between ideas is simply not compatible with pure competition and the simplistic invisible hand dogma. That is probably also the reason why neoclassical economists have been so reluctant to embrace the theory wholeheartedly.

msg-new-way-of-thinking

Neoclassical economics has tried to save itself by more or less substituting human capital for knowledge/ideas. But knowledge or ideas should not be confused with human capital. Although some have problems with the distinction between ideas and human capital in modern endogenous growth theory, this passage gives a succinct and accessible account of the difference:

Of the three statevariables that we endogenize, ideas have been the hardest to bring into the applied general equilibrium structure. The difficulty arises because of the defining characteristic of an idea, that it is a pure nonrival good. A given idea is not scarce in the same way that land or capital or other objects are scarce; instead, an idea can be used by any number of people simultaneously without congestion or depletion.

Because they are nonrival goods, ideas force two distinct changes in our thinking about growth, changes that are sometimes conflated but are logically distinct. Ideas introduce scale effects. They also change the feasible and optimal economic institutions. The institutional implications have attracted more attention but the scale effects are more important for understanding the big sweep of human history.

The distinction between rival and nonrival goods is easy to blur at the aggregate level but inescapable in any microeconomic setting. Picture, for example, a house that is under construction. The land on which it sits, capital in the form of a measuring tape, and the human capital of the carpenter are all rival goods. They can be used to build this house but not simultaneously any other. Contrast this with the Pythagorean Theorem, which the carpenter uses implicitly by constructing a triangle with sides in the proportions of 3, 4 and 5. This idea is nonrival. Every carpenter in the world can use it at the same time to create a right angle.

Of course, human capital and ideas are tightly linked in production and use. Just as capital produces output and forgone output can be used to produce capital, human capital produces ideas and ideas are used in the educational process to produce human capital. Yet ideas and human capital are fundamentally distinct. At the micro level, human capital in our triangle example literally consists of new connections between neurons in a carpenter’s head, a rival good. The 3-4-5 triangle is the nonrival idea. At the macro level, one cannot state the assertion that skill-biased technical change is increasing the demand for education without distinguishing between ideas and human capital.

Paul Krugman also has some interesting thoughts on the history of that dangerous idea — increasing returns: 

I have worked and written on a lot of topics. It is, however, the idea of increasing returns that has been the most important theme in my work. And it is my work in helping to clarify the role that increasing returns plays in economics that is the main excuse I have for my existence. The idea of increasing returns is, of course, a very old one, going back at least to Adam Smith. Nonetheless, until the 1980s economics was heavily dominated by what we may call the Ricardian Simplification: the assumption of constant returns and perfect competition …

The world isn’t really characterized by constant returns, and it was essential to go beyond the Ricardian Simplification, if only to be able to say to the policymakers that we had explored that terrain and found little of use.

If one admits increasing returns into one’s economic model, two other consequences follow. First, increasing returns are intimately bound up with the possibility of multiple equilibria. There can be multiple equilibria in constant-returns models, too, but they are rarely either plausible or interesting. By contrast, it is very easy to be persuaded of both the relevance and importance of multiple equilibria due to increasing returns … Second, once there are interesting multiple equilibria, you need a story about how the economy picks one. The natural stories involve dynamics — the cumulation of initial advantages that may be accidents of history …

All of this is fairly obvious, and indeed the history of thought in economics is littered with manifestos on the need to take into account increasing returns, multiple equilibria, dynamics, and the role of history … Nonetheless, it wasn’t until the 1980s that increasing returns really got into the mainstream of economics. I wasn’t the only one in the movement: Paul Romer, in particular, wrote several papers I wish I had written … applying increasing returns to economic growth …

Paul Krugman Incidents from my career

In one way one might say that increasing returns is the darkness of the neoclassical heart. And this is something most mainstream neoclassical economists don’t really want to talk about. They prefer to look the other way and pretend that increasing returns are possible to seamlessly incorporate into the received paradigm.

A couple of years ago yours truly wrote a review of David Warsh’ s great book on growth theory – Knowledge and the wealth of nations – for an economics journal. The editor accepted it for publication – but only if I was willing to lift out the parts where I highlighted Warsh’s discussion of increasing returns to scale and the efforts neoclassical economics over the decades had put into trying to willfully “forget” this disturbing anomaly. Moral: some dogmas are not to be questioned – at least not if you want to be published!

  1. October 23, 2013 at 12:16 pm

    Excellent article!

  2. Hawkeye
    October 23, 2013 at 1:34 pm

    Increasing returns or not, Equilibrium or not, most economic dogmas retain in their essence an Anthropomorphic explanation of economic growth (ideas, law & order, property rights, innovation, human capital etc.).

    Whereas the school of Ecological Economics places man’s exploitation of energy at the heart of the growth story:

    http://en.wikipedia.org/wiki/Economic_growth#Energy_and_energy_efficiency_theories

    The debate between the mainstream Anthropomorphic Orthodoxy and the energy-centric view is discussed at length here:

    http://www.golemxiv.co.uk/2013/03/the-slippery-grip-of-growth-guest-post-by-hawkeye/

  3. sergio
    October 23, 2013 at 7:03 pm

    Neoclassical economists are not “reluctant” to give up their vision of invisible hand, individuality, perfect competition, etc. Not even because they truly believe in all that.
    They do know that whole neoclassical economics is “false paradigm” which goal is just foolish people, under the cover of sophisticated models promote their ideology.

  4. BC
    October 23, 2013 at 10:01 pm

    Increasing returns to the top 0.01-0.1% to 1% owners of the system at the expense of the rest of the population and the ecosystem of the planet upon which all of us rely for survival; and hopefully more than that, say, an ecologically sustainable, socially acceptable, gov’t-guaranteed minimal standard of purchasing power of material consumption and well-being for all of us and our fellow non-human creatures.

    Accelerating techno-scientific advances and the potential for robotics, smart systems, biometrics, bioinformatics, nano-electronic sensors, etc., replacing most paid employment and purchasing power without replacement over the course of the next generation now requires a radical reboot, if you will, of the system of distribution of goods, services, income, and purchasing power for the bottom 90-99%. No longer should the top 0.01-1% enjoy the disproportionate gains from rentier income, wealth, and security from ownership of the means of production and distribution of goods and services while the rest of us struggle for subsistence and live in perpetual fear of impoverishment by no fault of our own.

    The top 0.1-1% have won; that game is over, and now it’s time that the “winners” demonstrate their beneficence and universal humanistic impulses to us “losers” and construct a system to share the wealth and “increasing returns” from the techno-scientific bounty with the rest of us before the system collapses and we are faced with a zombie apocalypse, “Mad Max”, or “Elysium” scenario.

    Working for pay that is insufficient for subsistence after taxes and debt service is unenlightened and akin to slavery and failed social, economic, and political systems of the past.

    Voluntary unemployment, lack of purchasing power, and material privation should be seen as appalling, unacceptable, even impossible, and relics of a distant past when we were not collectively capable of otherwise.

    We are capable as a self-aware species of so much more. Let’s get on with the realization of “enough” for all of us rather than obscenely wasteful concentrations of resources, wealth, income, and power to 1 out of 100-1000 of us at the expense of the rest of us.

    • BFWR
      October 24, 2013 at 6:20 am

      BC,

      Could not agree more.

  5. BFWR
    October 24, 2013 at 6:07 am

    The concept of monetary grace, the free gift, wed to technological innovation and the reality of the digital nature of our money system is the key to transforming the slavery of an unbalanced, asymmetrical and hence unnatural consumer financial paradigm of loan only, an economics based on scarcity and obsessive growth into one capable of both abundance and balanced resource usage, and the alignment of economics primarily with the intention of individual freedom as opposed to, merely and all too often exclusively, the otherwise perfectly natural and legitimate secondary considerations of power and profit, instead.

    Now that is both a potent and a pregnant idea.

  6. BC
    October 24, 2013 at 8:25 pm

    “Could not agree more.”

    “Now that is both a potent and a pregnant idea.”

    Indeed. Thanks, BFWR.

  7. ezraabrams
    October 26, 2013 at 5:42 pm

    .an idea can be used equally by many people
    total un adulterated nonsense
    in a practical sense, yes, the idea that you can put multiple submicron transistors on a single piece of silicon, to create a low cost, low power computer, is an idea that can be shared.
    But to make it happen requires a lot of practical knowledge, which is not that easy to come
    by

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