Gerard Jackson
BrookesNews.Com
Monday 8 September 2003

So-called new growth theories are a reaction to the neo-classical model that basically sees growth as the outcome of increasing homogeneous inputs of labour and capital. This simplistic explanation of growth results in the conclusion that diminishing returns must eventually set in as additional units of labour and capital render smaller amounts of output.

(This view of capital led Paul Krugman to erroneously claim that the "Asian miracle" was simply one of piling up capital goods that would eventually produce diminishing returns).

The steady state growth model assumes capital, labour, incomes and output increase at a uniform rate and that prices and all relative magnitudes remain constant. This approach to growth treats technological progress as external to the economic system. The new growth school, however, incorporates technological progress into its analysis, making it more dynamic than the neo-classical mechanistic model.

Instead of relying on perfect competition it emphasise profit maximisation, monopolistic competition and economies of scale. This leads to the conclusion that entrepreneurial activity in taking up innovations and inventions in order to capture economic profits will spur growth and more competition as knowledge of new techniques and innovations spread through the market place.

However, viewing the economy in this light leads to the peculiar conclusion that the market will 'under-invest' in innovations because no producer can capture the full social benefits of any breakthrough he finances. This alleged market failure is then used to provide an excuse to create investment loop holes and act as a rational for politicians and bureaucrats who want to pick winners.

There really is nothing new here at all. The concept of steady state growth was demolished by the Austrian economist Professor von Lachman more than 40 years ago. Likewise, the theories of perfect competition and monopoly competition were also demolished by other Austrians several decades ago. (That these facts are ignored in Australia is par for the course).

For the Austrians, growth is investment (the material means of production) which in turn comes from savings. Investment forms a heterogeneous capital structure consisting of complex stages of production; the more investment we get the longer and more complex the structure becomes as more advanced stage are added to it.

Because capital is heterogeneous the market performs the function, through the interest rate, of not only equating the supply of capital with the demand for capital but also determining the shape of the capital structure by allocating capital through time, so to speak.

Lackman pointed out (Capital and Its Structure) that the accumulation of capital leads to an increasing division and specialisation of capital goods that overcomes the law of diminishing returns. Austrian analysis does not overlook the role of institutions or entrepreneurial action: on the contrary, it has put great effort into analysing them.

History and economics demonstrates that there is no role for the state in picking winners. We have already suffered enough from the hubris of those politicians and bureaucrats who claimed they had superior knowledge to the market place. (Funny thing, though, this alleged superiority never allowed them, for some mysterious reason, to pick winning stocks).

The view that entrepreneurs will under-invest if they cannot capture the full social benefits of their innovations is a false one. It ignores the fact that patent laws were instituted to encourage and protect innovation and invention. One can even go so far as to argue that too stringent patent laws would actually result in under-investment in innovations.

After all, the aim of patent law is to grant the patent holder a monopoly. Moreover, companies do not try to gauge the alleged social benefits of their innovation; their concern is for market acceptance. If the market accepts the innovation then the company will obvious try to profit as much as possible from its investment.

One only has to look at the rapid developments in the computer industry in particular and electronics in general to see that the notion of under-investment in technology is completely at variance with the facts.

As for tax loop holes — why bother? A tax loop hole is a tax concession, the effect of which is to reduce a company's tax liabilities. To claim that industry needs more tax concessions for investment, research and development is to say no more than the tax burden is too high.

In other words, such claims pay homage to Professor Laffer. The solution, therefore, is to cut taxes.

Gerard Jackson is Brookes' Economics Editor