INTRODUCTION
The main topic of economics should be economic growth and development, “the nature and causes of the wealth of nations.” (Adam Smith)
The main questions are:
How do capitalist economies grow?
What is the relationship between economic growth and economic development?
What is innovation and its relationship to economic development?
ECONOMIC GROWTH
Economic growth is the growth rate of total output, usually measured by real Gross Domestic Product (GDP). Total output is not measured directly. Sales (nominal GDP) are added up and the growth rate calculated. The inflation rate is calculated separately and subtracted from the growth rate of nominal GDP. What remains is the growth rate of real GDP.
Between 1950 and 2000, the U.S. economy (real GDP) grew at about 3.5% per year. Since 2000, with two recessions, the growth rate has been around 2.0% per year. Even the recovery from the 2008-2009 recession has been only somewhat above 2.0%.
Small changes in compound growth over time leads to large changes in total output and real income per person. Between 1950 and 2000, real GDP increased over four times. Real GDP per person increased about three times. Real GDP per person rose from $16,000 in 1952 to over $50,000 in 2000. If the growth rate since the 1950s had been 2%, real GDP would not have increased four times until 2020, a generation later.
At 3.5%, it takes about 20 years for real GDP to double; at 2%, it takes about 35 years. If the US economy had grown at 2% rather than 3.5% since 1950, income per person by 2000 would have been $23,000, not $50,000. Real standards of living would have been substantially lower during this whole period.
But that is only part of the story. What if there had been no technological innovation since the 1950? The average American today would have had the income to buy three 12-inch black and white TV sets with six channels, three encyclopedias, and three rotary dial telephones. No air-conditioning. Virtually none of today’s health care and pollution control technology. Ten year shorter life-spans. No home computers or the Internet or cell phones. And the real cost of most goods available in the 1950s, in terms of hours worked needed to buy them, would have been higher than today.
ECONOMIC DEVELOPMENT
It is innovation, summarized as economic development, which is the driving force behind economy growth and higher standards of living.
Every day millions of people go to work with one thought on their minds. How to disrupt the status quo. Why? To increase sales and profits. And their income. How?
- Do it new. Start a new company. Develop a new product in an existing company.
- Do it better. Manage or organize the company better. Reduce unit costs.
- Do it different. Develop or buy new technology.
Much of competition is creative disruption. It is this collective behavior that is responsible for most of economic development today, and its consequence, economic growth tomorrow.
MATURE COMPANIES
Most companies, products and services grow near the average growth rate of the economy. This is especially true of consumer product companies. They are mature companies with established or dominant products and services. Mature companies include most large corporations. Market or industry structure tends to be oligopolies, markets dominated by a small number of companies.
Growth in demand for the products and services of mature companies depends mostly on growth in total real income, which is equal to the growth in real GDP. Real income and real GDP can grow when the prices of existing products and services fall. Consumers have more income to buy products and services.
Typical corporate strategies of mature companies are advertising and marketing of brand names, increasing productivity and reducing costs, extending product lines and developing market niches, and acquisitions. Much of their behavior can be described by conventional economic theory and business management ideas.
This part of the economy can be describe by diminishing returns to investment and production, shifting demand curves, flexible prices, and movement towards market equilibrium. But diminishing returns is a short-run concept. In the longer run, a mature large company with dimishing returns is often overwhelmed by innovation from other, often newer companies. Successful new companies experience increasing returns (fall in unit costs as production increases) in the production and sale of new products. New large companies are created, often becoming the dominant companies of a transformed industry. Older companies may continue to exist but often smaller in size, less market share, or merged with or acquired by another company.
Mature companies rely mostly on growth in aggregate demand and cost savings partly from productivity gains, which depends on innovation in inputs from the capital goods and services sector.
INNOVATIVE COMPANIES
Successful innovative companies drive economic development. They are started to create new products and services, new production systems, develop new markets. Some innovative companies improve on existing technology (“useful knowledge” applied to develop material goods and services), put existing technologies together in new ways, or develop new applications. They develop potential demand. Many experience hypergrowth (high exponential growth), many times greater than the average growth of mature companies.
Corporate strategies include continuous innovation with high levels of research and development. Industry structure is fluid. They create new supply networks, which in turn leads to more innovation.
Innovative companies create demand, which is part of the innovative process. Innovative companies must convince potential customers or consumers of the value to them of the new product or service. They show potential customers and consumers how to use the new product or service. At first, they often offer primitive products or services at high relative prices. But continuous improvement and follow-on innovation, economies of scale, new skills and knowledge of employees, and learning curves among both customers and producers change products and services offered and drive economic growth.
The success of an innovative company partly depends on its ability to exploit existing “enabling” networks, capital equipment, and supply networks. These, in turn, exist because of past innovation, past economic development.
There are whole sectors of a modern economy in which companies compete primarily on the basis of continuous innovation. The capital goods sector including most of information technology provides much of the new production and control technology to the rest of the economy. The pharmaceutical sector including biotechnology contains over thousands of companies developing new drugs and medical equipment. The entertainment industry must constantly produce new content. The telecommunications industry, a vital “enabling” network, continues to rapidly upgrade and replace systems with new technology from semiconductor and related industries.
Prior success in economic development prepares an economy for current development. The opposite is true. England, which began the Industrial Revolution, did not keep up with the latest innovations in new industrial products and mass production in the late 1800s and early 1900s. In 1930s and early 1940s, English scientists and engineers developed jet engines, computers, radar (microwave), and penicillin. After WWII, the structure of DNA was discovered in England. But England did not have the industrial capacity and know-how to develop and mass-produce new products from these technologies. England’s attempts to develop a civilian computer industry and a civilian jetliner industry failed.
England was forced to share the new technology with the United States in WWII so they could be mass-produced here. Developing the new technologies created Boeing and the aviation industry, IBM and the computer industry, Pfizer and the pharmaceutical industry, the modern telecommunications industry, and the American biotech industry. It was Americans who first benefited from all this invention, who experienced rising standards of living because of innovation and economic development.
INNOVATIVE COMPANIES AND ENTREPRENEURS
This is a stylized narrative of the path of economic innovation, the dynamics of the economic system. The resulting economic structure is oligopoly. The supply network is characterized by bilateral oligopoly (oligopolies on both sides of a market).
Innovation begins with public knowledge, often scientific or mathematical discoveries that do not seem to have any practical application. Imaginary numbers, general equations of electromagnetism, the Second Law of Thermodynamics, E=mc**2, the structure of DNA, the conductivity of solids, and many other recent advances in knowledge. Eventually, scientists, engineers, inventors, and entrepreneurs begin to see possible commercial, profitable applications of this scientific knowledge. Then entrepreneurs begin to see possible commercial (profitable) development of the resulting technology. Because of the uncertainty of how the technology would meet potential wants and whether it will be profitable, usually many companies try to develop different versions and applications of the technology.
Much of the work is in engineering, production planning, design, distribution and educating potential customers. Often much of the innovation includes exploiting existing “network” technologies, such as transportation networks, electrical grids, mass media, telecommunications, or the Internet.
Most of the early companies go bankrupt. A few companies successfully develop different niches of the potential market, successful variations of the basic technology. In the past, higher transportation and information costs might limit the geographical reach of any one company, allowing local and regional companies to succeed. As distribution and information costs come down and new production technology leads to economies of scale, a few of the innovative companies take over a large percent of a wider, growing market. Many large companies are now global and are called multinational corporations (MNCs).
Typically, no one version of the technology gives the best benefit/cost ratio to all customers or consumers. Companies do not compete directly. There is no industry demand curve. Differentiated products or services aimed at developing different segments of the market lead to an oligopolistic structure of the market or industry. Unit costs fall; quality improves. Total demand increases. Each company attempts to develop and protect proprietary information, be it better engineering, more efficient production, brand names, patents, as the basis for growth in market share and economic profit.
But with time, patents expire, engineers and managers leave existing companies to start their own companies (an important source of continuing innovation), products are “reverse engineered” or imitated, and “industrial espionage” diffuses knowledge. Proprietary information leaks out to other companies such as when large companies transfer operation and technology to other countries. With standardized products and slowing innovation, economic (above average) profit begins to disappear. Products become commodities, meaning customers or consumers choose mostly on the basis of price. Market structure and market shares tend to stabilize. New companies might enter to better serve a specialized niche of the market. Some are acquired by large companies with declining internal investment opportunities; some replace existing companies as one of the dominant companies. The overall structure remained oligopolistic, often with the distribution of company size represented by a relatively stable power law.
Another source of diffusion of knowledge and structural stability is that companies providing inputs, often large capital goods or IT companies, offer standardized machinery, production systems or information technology to all existing corporate customers. Innovative solutions to a problem of one customer are now available to all. Capital goods companies are crucial to continuing innovation since this is how they compete. But now inputs embodying innovation are available to all.
This is part of a more general process where technology and information become widely known. Much of the change in an industry is in cost reduction, relatively minor product changes, and marketing. Rates of return on new investments approach the company’s cost of capital. Diminishing returns on new investment has set in.
Often, a new round of basic innovation begins. New companies, often outside the industry that innovated in the past, typically drive replacement technology. Existing large companies have large investments in existing technology and much of the firm-specific knowledge is based on this technology, existing distribution channels, a large customer base, and existing marketing strategies. One should also not underestimate internal resistance to major change in any large organization, especially if the company has a long history of profitability and market dominance.
So the innovative process continues. No company, no matter how big and how profitable, is immune from attack. Think of General Motors (Toyota), Toyota (Hyundai, Kia), all auto companies (Tesla), the old AT&T (MCI, Nokia), IBM (Intel and Microsoft, Dell), Sears (Walmart), Walmart (Amazon), U. S. Steel (Nucor), RCA (Sony), Sony (Samsung), Eastman Kodak (Fuji, digital cameras), Xerox (Canon), Polaroid (digital cameras), Nokia (Apple), and many others. New, large companies based on new or improved technology appear. Old industries are transformed and new industries created. But the dominant industry structure remains oligopolistic.
SUMMARY
Economic growth and higher standards of living are functions of economic development. Economic growth is driven by:
Current technological and organizational innovation.
Past technological and organizational innovation.
Organizational innovation is partly driven by innovation in information-handling technology and systems.
Development can be seen as a consequence of generating new technology that entrepreneurs use to start new companies.
Innovation creates disruption. A major macroeconomic and political problem is how to reduce the personal and social costs of this disruption. Artificial intelligence and robotics may create more economic and social disruption in a shorter period of time than any innovative technology in the past.
Most companies, most divisions of companies, most product lines grow about at the same rate as the national economy. They can be described using traditional economic theory and business practices. But it is the innovative companies that provide future growth, new products and services, and new processes. They cannot be described using traditional economic theory.
Most companies grow because of a growth in demand. Demand, in turn, is mostly a function of a growth in real income. Growth in total real income is equal to the growth rate of the national economy.
Organizational innovation depends partly on technological innovation in electronic communications and information technology. Historically, the processing of data and information was a major bottleneck to the expansion of large corporations.
Reduction in unit cost, increasing returns to scale, depends on increases in productivity (greater output per unit of input). Economic growth, and economic growth per capita, continues as long as innovation (economic development) overcomes diminishing returns to investment and production in existing technologies. A key role in the process is continuous innovation in the capital goods sector. Capital goods companies, including information technology companies, compete on the basis of reducing costs, increasing productivity, increasing capacity, and customizing applications for their corporate customers.
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CASE STUDY:
A CAUTIONARY TALE: ENGLAND AND THE INDUSTRIAL REVOLUTION
England, more than any country, started the Industrial Revolution in the late 1700s. And for over 150 years, England continued to discover new products and technologies. Yet England eventually fell behind the United States and Germany in technology and economic growth. What happened?
The seeds of England’s relative economic decline were there right at the beginning. Millwrights, mechanics with specialized knowledge of how to build wool and cotton mills and their machinery, felt frustrated because they seldom became part owners and couldn’t find financing to start their own mills. Some illegally emigrated to the United States and France. Much of the early American textile mill technology was due to English immigrants. The first cotton spinning mills were designed by an English millwright (Samuel Slater) financed by a Providence, Rhode Island merchant (Amos Brown). By the middle of the 19th century, American cotton mills were more efficient than English mills; much of the venture capital for the industry was provided by Boston merchants.
England (actually, a Scot) developed the modern steam engine. Later, the improved high pressure steam engine was developed at almost the same time in England and the United States (by Oliver Evans). This engine was critical to the development of railroad, steamboats, and later steamships. The first general purpose railroad was completed in England in 1830. The first railroad locomotives in America were imported from England. But within two years, American engineers and mechanics were modifying the English locomotive, making it more flexible and powerful. American railroad companies developed cheaper and faster ways to lay track. By 1860 over half the world’s track was in the United States and America was exporting railroad expertise and equipment.
Already in the 1850s, English engineers were alarmed by superior American production techniques. England began to fall behind the United States and Germany in the 1870s, at the start of the “Second Industrial Revolution.” Part of the problem was the inability of England to stay ahead in its dominant industries.
The rapid mechanization of the textile industry displaced British exports as British firms failed to switch from the jenny or mule to the new, faster and cheaper technique of ring-spinning. By the end of the 19thcentury, the average American cotton spinning mill’s labor productivity was 30% higher than the average English mill. England would eventually lose one of its largest export industries.
British machinery firms such as Platts exported the new automatic looms to Japan and other countries but failed to find buyers in the home market. By the 1930s, Toyoda (later Toyota) of Japan had improved Platt’s technology to the point where Toyoda was exporting power looms back to England.
Coal mining was a major industry in England but productivity began to fall until output per head in British coalmining was only half of that found in the American coal industry by 1914.
Richard J. Evans, The Pursuit of Power: Europe 1815-1914, 300.
England invented the two ways to produce large amounts of cheap steel. The inventors licensed the processes to both English and foreign companies. One purchaser was Andrew Carnegie, a Scottish immigrant in America. Within thirty years, America was the world’s low-cost producer and produced over half the world’s steel.
This had profound economic consequences. Large amounts of cheap steel were crucial to the development of better machine tools, better railroads, skyscrapers, and automobiles.
An English chemist discovered the first synthetic dye for cloth, the basis for the modern chemical industry. But the development of the synthetic dye industry occurred in Germany. It was the basis for the world dominant German chemical industry. German companies went on to discover and develop new chemical products, including high explosives that gave Germany a decided edge in artillery in World War I.
Germany and the United States developed the new technologies of electrical equipment. America dominated the global production of automobiles. Ford was the largest auto assembler in England. By 1900, the United States had replaced England as the largest economy in the world.
The radio was invented and first exploited by an Italian immigrant in England. But the radio industry was developed in the United States by a Russian immigrant (David Sarnoff) using the financial resources and patents of four of America’s largest corporations. It was a short technological step to develop television and computers, which originally used radio vacuum tubes manufactured by RCA.
The structure of DNA was decoded in England. Yet there were no English equivalents of Amgen, Genentech and the hundreds of other American biotechnology companies.
In World War I, England first developed and deployed the tank. But its further development, and a strategy for modern warfare built around the tank, was done in Germany. In 1927, the English army spent more money on hay for horses than fuel for tanks. In 1940, England paid the price as German tanks destroyed the English army.
Before and during World War II, England discovered or developed a host of important new technologies – penicillin, radar, computers, jet engines. But England did not have the resources or technology to improve and mass produce these products. Knowledge of all four was shared with American companies during World War II and became the basis for large new American industries.
Losing technological and economic leadership can have serious consequences for a country’s political and military power.
I think the point is clear. Inventing a new product or process does not lead to economic leadership or economic growth if the country does not have the intellectual, productive, organizational, and financial resources to develop them. England did not start engineering, scientific and technical schools as did the U.S. and Germany; there was no English equivalent of MIT or the German scientific research universities. English companies could not match the R&D labs of AT&T (Bell Labs), GE, du Pont, IBM, and RCA. In England, engineers (lumped together with mechanics) and entrepreneurs (often from dissenting religious groups or minority groups) were considered social inferiors. “Venture capital” (except for the railroad investment craze in the 1840s) went into trade financing and overseas investment rather than risky new industrial enterprises.
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EXTRA CREDIT
ECONOMIC GROWTH, DEVELOPMENT AND ECONOMISTS
Almost all the great economists – Smith, Ricardo, Malthus, Mill, Schumpeter, Keynes – believed that a capitalist economy was unstable, cyclical, or would reach a point where per capita income would stop growing. For Schumpeter and Marx, economic resources would become increasingly concentrated into fewer corporations. Either the economic system would collapse (Marx) or probably become socialist (Schumpeter).
What kept this from happening, why capitalist economies continue to grow and increase people’s standard of living over long periods of time, is innovation. Marx and Keynes had glimpses of the long run growth and development possibilities of industrial capitalist economies. Marx commented that the English economy he studied for over 30 years had changed (developed) and that at least part of the working class was becoming better off. Keynes saw a potential future where compounded economic growth would lead to higher standards of living and more leisure. But these insights had little influence on economic theory, political economy, or economic policy.
