Home > Uncategorized > Economics textbooks transmogrifying truth — growth theory

Economics textbooks transmogrifying truth — growth theory

from Lars Syll

The above vidoe is one in a series of videos where Alex Tabarrok and Tyler Cowen present their economics textbook Principles of Economics. In a later video, ‘ideas’ are introduced into the Solow growth model. But, not with a single word does one acknowledge that this in total contradiction to the Holy Grail of their mainstream economics — the “iron logic of diminishing returns.”

In Paul Romer’s Endogenous Technological Change (1990) knowledge is made the most important driving force of growth. Knowledge – or ideas – are according to Romer 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 and the “iron logic of diminishing returns.”

tumblr_mdp9iml7jb1r75x33o1_1280Neoclassical economics has tried to save itself by more or less substituting human capital for knowledge/ideas. But Romer’s pathbreaking 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 from Romer’s article The New Kaldor Facts: Ideas, Institutions, Population, and Human Capital gives a succinct 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.

Monopolistic competition, product differentiation and increasing returns — generated by e. g. nonrivalry between ideas — are  simply not really 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 new theories of trade, economic geography and endogenous growth whole-heartedly.

This is where the darkness of the mainstream neoclassical heart is situated. And this is something neoclassical economists don’t really want to talk about.  Mainstream neoclassical economics have over the decades willfully “forgot” this disturbing anomaly.

Pretending that increasing returns are possible to seamlessly incorporate into the received paradigm, Tabarrok and Cowen, like so many other mainstream economics textbook writers, transmogrify truth.

  1. June 5, 2017 at 1:46 am

    “neoclassical economics with its emphasis on decreasing returns to scale”

    Ugh. Do these people think before they come out with these theories? An argument can be made for decreasing returns to scale in the HR department, but when it comes to use of capital, are they seriously arguing that capital infrastructure has a negative benefit? Considering that this fact of ignoring capital accumulation also underpins Ricardian trade theory, can we define neoliberal economics as “An economic theory that first posits that capital accumulation is impossible and then states that progress is measured in this impossible accumulation?”

    In their defense, this could be discussed at a given capital build-out level, but if so, this is an important detail that must be brought up each and every time these ideas are used. I don’t know about you, but I have never heard an economics pundit placing an asterisk appropriately based on reservations like this.

  2. M. Treloar
    June 5, 2017 at 3:36 pm

    I have a question: why does the Solow Model (AeLK) NOT include investment (capital) as a critical factor in economic growth?

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