Paul Romer Claims that Knowledge is the True Fountain of Wealth – 1 of 2

Paul Romer’s Endogenous Technological Change opens wide vistas

Professor Romer will win the Nobel Prize for economics for Endogenous Technological Change (Oct 1990, JPE) within the next two years. That is my fearless forecast. For innovators, his paper has defined opportunities from a new category of products differentiated by embedded knowledge.

Professor Romer will win the award for new insight and new math tools that resolved big issues in classical economics. His research allowed taking out the assumption of perfect competition and accepted increasing returns as typical with technology. With new math tools allowing a solution, it brought technical change in from the cold instead of being a mere residual externality.

Robert Solow won the prize in 1997 for work done in 1958. He explained that only 20% of American growth came from traditional factors like land, labor and capital. The difference between growth from factors and actual growth was a remainder and residual attributed to technical change and unexplainable by the then state-of-the-art in economics. The residual was bigger than what could be analyzed. But the math and the assumptions of replaceable inputs and perfect competition, could not explain the residual further. Professor Solow’s work was used in growth accounting and provided great insight despite technical change remaining a block box for economists.

Professor Romer’s insight on technology was succinctly stated in his paper’s abstract above from which I quote lengthily:

“The distinguishing feature of the technology as an input is that it is neither a conventional good nor a public good; it is a non-rival, partially excludable good. Because of the non-convexity introduced by a non-rival good, price-taking competition cannot be supported. Instead, the equilibrium is one with monopolistic competition.”

Professor Romer first saw technology as non-rival. It cannot be used up even when shared. He also saw it as partially excludable. That means one can take ownership of technology, say, by embedding it in a hard, traded product like a computer, an enzyme powder or genetically-modified seed. The greater the value of knowledge embedded, the greater the value of the item traded.

In defining the importance of exclusion in a knowledge economy, Professor Romer gave more life to the intellectual property rights. Trading commodities, which merely embed traditional and commonly known know how, with computers is the sure way to unfavorable terms of trade.

He accepted that decreasing returns (i.e. convexity) is not necessarily true with technology because of technology’s non-rivalry, i.e. non-rival goods can be ‘owned’ by many at the same time and if distributed at low cost, say through the internet, the effective fixed cost per unit constantly reduces and so, conversely, there is increasing returns.

He threw away perfect competition as a simplifying assumption in his model.

At the same time, technology entrepreneurs intuitively grasped his insights. They created new value from technology itself, created new business models or outflanked traditional industries.

For new innovators, the learning in terms of opportunity-seeking starts with creating products with embedded knowledge. Then using this knowledge as the differentiation against commodities, ie organic rice, cleaner gasoline, pressed dinner plates from waste coconut leaves, etc.

(Click here for Part 2 of 2.)

P.S. Author David Warsh did the almost impossible by writing an exciting story about Paul Romer’s journey of discovery in Economics in this book, Knowledge and the Wealth of Nations, 2006, Norton.

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