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Thursday, July 22, 2004

WHY THE US HAS BEEN THE RICHEST COUNTRY SINCE THE 1880s: 7th in a Series

This, the 7th article in the series on the US's economic performance --- especially its remarkable innovative prowess, technologically and otherwise --- is a direct continuation of the previous article. Originally, when that 6th article was written two days ago, the argument that's about to unfold right here would be tacked onto the end there, starting with Part Four. Why the change? Well, as it turned out, the summary of the main points in the first five articles took longer than the buggy prof had initially thought. No surprise really. In the flitting vagaries of a bugged-out professor's mind, the surprise really is that a sustained line of analysis can be snatched out of the tumbling ideas and their twists-and-turns and set down in hard print as frequently as they appear to do so on this site.

Or so it seems to my not entirely bias-free quirky view.


PART ONE:
THE SUPERIORITY OF THE US ECONOMY'S INNOVATIVE SYSTEM


Why This Superiority Is A Puzzle For Mainstream Economics

Our jump-off point here is why the US --- the richest economy in the world in per capita income for 125 years or so, roughly half the time since the industrial revolution of the late 18th century --- has been able to achieve a superior growth rate in its people's material standard-of-living for so long. It defies the theory of convergence catch-up growth, however interpreted. It also is a big problem for maintstream economics --- AKA, neo-classical theory, a term that will be clarified in a moment or two.

In standard neo-classical economic theory, to be blunt, the US's superior success shouldn't persist: if its economy does things better in certain key respects than other economies --- especially revolutionary innovative technologies, and the speed with which they are brought to the market-place by start-up firms --- then those other national economies ought to quickly emulate each and every one of American best practices . . . whatever their substance: 1) the ways we organize R&D, or 2) the links between university, government, and business R&D, or 3) the manner in which we train managers and scientists and engineers, or 4) the scope and vigor of entrepreneurial risk-taking here. For that matter, the best practices --- we're just ticking off some of the more important ones --- include 5) the ability of new financial institutions in the US to fund risky start-up firms like Microsoft, Apple, Walmart, Home Depot, MacDonald's, CNN, Amazon, Yahoo, or Cox.net . . . just as, by extension, best practices in finance also include 6) the ways in which the stock markets here have exerted unprecedented pressures on well-established corporate enterprises, if they're performing poorly, to restructure or risk unwanted mergers or take-overs from outside share-holderrs.

Essentially, there are only two reasons why mainstream economics --- another name for neo-classical theories --- that could explain the US anomaly.

A sidebar clarification: Neo-classical economics refers to big advances in micro-economic theory in the late 19th and early decades of the 20th centuries: more specifically, such theoretical breakthroughs as

*Carefully analysis of supply-and-demand curves, including the notions of consumer or producer surplus;

*The introduction of marginal analysis and the notion of opportunity costs to explain them, including substitution and income effects;

*The concerns with allocative resources efficiently and incentive systems to that end, and

*The identification of market-failures, such as monopoly or externalities or public goods or information problems, and debates about what to do with them. Technically, a market-failure is anything that prevents an economy from reaching a Pareto optimal-frontier .

*The ways in which a capitalist market economy can be organized to maximize such efficiency in allocation . . . a movement to the Pareto frontier, given an initial distribution of income and perhaps a once-and-for-all lump-sum redistribution.

*The creation of public choice theorizing as a counter to market-failures. It postulates a whole series of government-failures, the bulk of which derive from the lack of competition within the provision of public goods and public decisions, together with the motives of politicians to be re-elected and bureaucrats to expand their agencies' budgets and tasks irrespective of their performance. The ability of certain producer groups to organize more effectively than other groups (even the vast majority of consumers in an economy ) --- hence lobby and influence politicians for special privileges such as winning tariffs or quotas to protect themagainst foreign competition --- is also part of public choice theory. It emerged in the 1960s and 1970s, winning a Nobel prize for one of its founders, James Buchanan.

*More recently, work for which three US economists won a Nobel prize in 2002, certain kinds of new information and coordination problems within national economies --- including agent-principal problems. Such work has also influence theorizing about the growth of national economies.


Back now to our main concerns, in particular . . .

 

Reason One In Mainstream Economics Why Best Practices
Don't Spread As Postulated:


If the best practices of any one firm, say managerial, aren't emulated by other firms within the industry in question, either quickly or easily --- even within the domestic economy of one country --- it's because markets aren't perfectly competitive, and forms of monopolistic competition prevail.

Most markets, of course, aren't perfectly competitive. That recognition is part of neo-classical economics too. It was first explained and elaborated on in the 1930s, both in this country and in Britain, by some gifted economists --- Edward Chamberlain at Harvard, Joan Robinson at Cambridge, Ronald Coase, an Englishman who would get a Nobel prize at Chicago --- and refined then at greater length with further concepts about transactions costs and information problems and the use of game-theoretical bargaining models making lavish use of the Nash equilibrium (remember, A Beautiful Mind?). In such imperfectly competitive markets, to focus on our present concern here, the dominant firms --- a monopolist, a duopolist, possibly an oligopolist (3 or more giant firms in the industry) --- will earn economic rents : a return on their investment capital and costs of production higher than a perfectly competitive economy would bring about in the long run. The latter is characterized, of course, by two things: by large numbers of firms and by free entry and exit that, over time, will compete successfully to reduce the profits of the dominant firms to just cover all marginal costs.

In the end, then, what are we left with as an explanation for the failure of best practices to be emulated, whether quickly abroad or at all?
Well, about all a neo-classical theorist can argue is that if other countries don't quickly emulate superior American innovative practices --- such as managerial, R&D, financing, and entrepreneurship --- then it's because perfectly competitive markets don't prevail in the industries where such best practices exist. That's true either of the market-structures within the American economy, or --- more germane to our interests --- most likely abroad.

 

Is This Right?

The latter argument, note quickly, isn't wrong: rather, given the assumptions that are postulated about market structure, it's more or less tautological and far from providing insight into what the barriers are --- whether abroad or in the US economy -- that prevent perfectly competitive markets from prevailing: including, it should be added, free trade.

That's one problem with the explanation: it's either a fully tautological explanation or, if not fully that, platitudinous; little else.

Another problem rears up too: the failure in mainstream economics to grasp why --- even if revolutionary technologies like the automobile or electrification or computer chips are invariably brought successfully to the market-place by start-up firms: Ford Motor Company, Edison Electric, or Intel --- the successful start-ups will, fairly quickly, become giant firms and earn rents . . . higher profits, recall, than would be the case in a perfectly competitive market-structure. And yet, as we'll see, such rents aren't incidental to radical technological innovation.

Tersely put, those rents are the justified return on the risk-taking that the innovative firms need to cover their initial uncertainties, their costs in dealing with them, all their experimentation with brand new products of a far-reaching sort, and then their production and marketing. Not to forget, as long as we're listing these risks and costs, future systematic R&D to improve on the new products, whether the Model-T Ford, the DC-3 airplane of the 1930s, the first Pentium computer chip, or the initial flipped hamburger at the first MacDonald's restaurant in 1940.

 

What Rents Do For Innovators

Without those rents --- higher-than-average-profits (to vary the meaning) --- bold risk-taking entrepreneurs would be far scarcer and far less successful in the market-place.

Even if a few other firms do manage to emulate or even improve eventually on the innovations --- General Motors or Toyota vs. Ford, Boeing or Air-Bus vs. Douglass, Burger-King or Wimpy's vs. MacDonald's --- there won't be many of them; and almost always there will be increasing returns in the production of such products, leading to giant corporate firms and monopolistic competition, not perfect competition. Meaning? Meaning, to put it simply, that these other firms at home or abroad will likely earn rents too, even if, in the process, not as high as would be the case in a fully one-firm monopolistic industry.

Sidebar clarification of a slightly technical sort:There won't just likely be scale-returns for the new innovative firm, but also positive externalities, first within the innovating firm itself, then as spillovers onto surrounding firms that do emulate or improve on the innovator's best practices, then --- something that is again part and parcel of American innovative capacities more noticeably than the case abroad --- a diffusion of the spillovers to other industries and throughout the economy. That was and is the case of the radically restructuring technologies in information and communications, ICT. The US economy was able to first double and then almost double again its rate of overall productivity growth when, finally, after almost two decades of investment, workers and managers in both private firms and public agencies learned to put the new ICT to effective use. A learning curve was involved here. It took time to master them.

By contrast, though West European countries invested at fairly high rates in ICT in the 1990s, their rate of productivity growth --- far from benefiting from them --- has actually fallen off sharply since 1996. It's a big puzzle, but it does at least draw attention to rigidities in their national institutional structures and their policies, with some exceptions for Finland, Sweden, Denmark, and Ireland --- all very tiny countries.


 



Reason Two Why Best Practices Aren't Easily Emulated,
Especially Across Countries


A twist in the neo-classical theoretical apparatus in dealing with this puzzle was pioneered by Robert Solow of MIT when, back in the mid-1950s, he created the standard growth model to explain economic growth within and across countries.

The twist in the Solow neo-classical growth model is that technological innovations are seen as public goods: once the new technologies are invented and become marketable thanks to at least one profit-making firm, they are, it's claimed, made available to all other firms in the same industries, whether in the original national economy or abroad. By definition, a public good --- in contrast to a private good, which is what the capitalist market produces overwhelmingly --- can't exclude its use or benefits by non-contributors, however numerous. That means, in the Solow model, it should be readily available to the firms in other countries and diffuse around the world, leading, among other things, to convergence catch-up growth by laggard economies on the front-runners that are themselves on the technological frontier.

 

To Understand The Argument Here, A Brief Clarification of The Solow Model Is Needed.

The basis of all later work on economic development for which Solow won a Nobel prize, the model postulates that per capita income growth in a national economy is a direct outcome of growing capital investment on the one hand and a growing labor force on the other. Technology is crucial, but operates from outside the model itself --- that is, to put it bluntly, from outside the economy of any country. (In statistical terms, technology's saving impact here isn't itself explained. It's an exogenous variable, influencing the endogenous causal variables, cumulative rates of capital investment and labor force growth, but how and why are matters never accounted for.).

Over time, to put this in plain English, the rate of economic growth in the Solow model is subject to diminishing returns as physical capital accumulates,: the 2nd steel mill in a national economy may double output, but the 22nd may --- even if it costs the same to set up and run --- might only increase output by 5%. On top of that, depreciation of the old steel-making furnaces and related equipment --- read: the cost of replacement furnaces and equipment --- will pile up and cost more at the margin than the marginal output of newer capital in the newer steel mills.

At that point, Solow's model projects that a stationary steady-state will emerge where the rate of capital depreciation exceeds the rate of new capital investment, and hence the rate at which GDP and especially per capita grows will slow down and head toward zero. (Note that there are variants of what the postulated end-state growth rate will be; they entail some technical debate that distinguishes between rate- and level-effects, plus the meaning of long-term growth rates over several decades, but they need not concern us here. Note too that an augmented Solow model that emerged in the 1980s qualified labor-force growth by the use of proxies for its skills and overall quality. The augmented model fits existing data about economic growth rates across countries better than the original model, with its large error term in growth accounting, but it still entails a fair amount of differences in total factor productivity across them too.)

 

Technological Salvation To the Rescue

But note. A stationary end-state isn't an inevitable outcome for a national economy. Enter technological progress, from outside the model . . . a kind of manna from heaven.

In particular, once new technologies are invented and brought to the market-place, such technological progress won't be confined to just one economy. It can't be in the Solow model and neo-classical spin-offs. That's because, you'll recall, technological innovation of any sort --- including the revolutionary new ones --- is a public good. It can always be imported by the firms in other countries, and in one of four ways:

1) Paying a license to the innovative firm abroad for transferring and using the technology --- say, a Japanese black-and-white TV firm paying RCA for its color technology.

2) Encouraging RCA to implant itself in the Japanese or French or Brazilian economies, for production, marketing, or even R&D of some sort. (There can be various forms of multinational implantation, including joint-projects with local firms).

3) Engaging in reverse engineering, a Japanese specialty, which is to import the machines, then break them down and build them anew around the patent process.

4) Engaging in piracy, a Chinese specialty, which is simply to ignore the patents (and even trademarks) of other firms abroad and produce the same good, then bog down the foreign innovator in red-tape and legal rigmarole.
 

So What Then Accounts For the Real World? .

As simple observation shows, most advanced technologies don't clearly radiate quickly around the world, or even --- for about two-thirds of the countries in the world that are not much developed in per capita income --- slowly so. And that, in turn, leaves the main issue at stake unexplained by the Solow model and its practitioners. After all, if technologies are truly public goods, then we want to know what, precisely, are the obstacles operating in most countries that prevent them from all being at or near the technological frontier?

That there are barriers to even the rapid diffusion of ICT in the EU and Japan --- at any rate compared to the US --- can be easily shown by a series of . . .

 

Graphic Illustrations of Barriers To Innovation In The EU (and Japan)
Compared To The USA In ICT


(i.) Consider initially the growth of GDP, employment, and labor productivity in the three regions since 1996. (Note: these three diagrams are taken from an EU Commission Study, The Role of ICT Investments in Solving Europe's Economic Problems, by Erkki Liikanen, September 23, 2003. All references should be strictly made to the EU study, one of a series of impressive comparative works that the EU Commission regularly publishes, much to their credit.)

 

OUR CONCLUSION?

If the US remains the most innovative economy these days, in an era of marked technological flux --- the tumult and change accentuated by the rapid spread of globalizing capitalism in above all Asia --- the differences between the US's big benefits as the pioneer of ICT and the knowledge-based economy on one side and Japan and the EU on the other can't be due to lower rates of R&D expenditures or lower rates of investment in those technologies. The differences in those rates are fairly negligble (save for tiny Sweden and Finland). American superiority in innovation --- something that goes back to the 1880s now, when US per capita income forged ahead of Britain's --- has to lie in other influences.

What those are is the subject of the next article in this series. As you see, they are multiple in number; and together, they add up to a different sort of system of national innovation in the US compared to its main EU and Asian rivals . . . including a much greater flexibility in labor markets as well as in people's attitudes and behavior when it comes to adapting to radical economic and technological change --- all part-and-parcel of what Joseph Schumpeter and his followers these days call "creative destruction."