New Growth Theory (NGT)
It argues that in pursuit of profit, the real GDP per person is bound to keep increasing over time.
What is the New Growth Theory (NGT)?
The New Growth Theory revolves around the concept that human wants, which are assumed to be unlimited, will drive the productivity and economic growth of the economy.
It argues that in pursuit of profit, the real GDP (Gross Domestic Production) per person is bound to keep increasing over time.
Thus, inarguably the growth is tied to the people of the economy. Their wants drive up the purchasing and investing decisions which drive up the economy.
It challenges the views of the Neoclassical theory, which reasons specific uncontrollable external forces to be the reason for economic progress.
However, according to the theory, particular emphasis is given to entrepreneurship, knowledge, technology & innovation as the driving forces for economic growth.
To constantly gain profits, there is a need to always come up with new products or better technology which is one of the critical features of this theory since now there is competition to maximize profits.
These innovations and technology depend greatly on incentives in terms of profits they will offer in the future. People can choose their study area, and if the incentives are great, they will work harder to bring newer technology to the table for greater profits.
In theory, a striking feature is that knowledge is taken as a factor that is not subjected to diminishing returns, unlike other assets like land, machinery, etc.
Knowledge is not a physical quality but can consistently be grown in a firm or an economy.
Key Takeaways
- According to the NGT, Human capital is the most valuable resource for economic prosperity and growth.
- NGT focuses on three critical features for a prosperous economy; Knowledge, technology, and entrepreneurship.
- Knowledge is not a physical quality but can consistently be grown in a firm or an economy.
- Unlike other factors, knowledge is not subjected to diminishing returns.
- NGT focuses on moving away from extreme reliance on physical assets and expanding knowledge in the economies.
- Government and private enterprises are advised to be attentive to institutions that can help develop the knowledge base.
- Technological progress is not coincidental; it depends on the economic incentives that make one strive hard to seek it.
- It challenges the views of Neoclassical economics that don't give a reason for the technological change; the New growth theory, however, explains the cause of technological progress as well.
Understanding the New Growth Theory
The New Growth Theory focuses on investing in Human Capital since they are the cause for innovation required to earn profits.
The idea is to nurture innovation to encourage and develop more ideas, concepts, and technology.
The theory insists that private companies generally undermine the importance of knowledge and lack proper attention & investment for innovation.
They generally believe that it's the government's job to invest in access to better education and the research & development sector of the private sector.
For example, a firm can invest in human capital by allowing some of its workers to work on independent research projects to develop innovative ideas that the company can use.
The incentive behind these projects is to generate more profits for the organization. Software & app development and other technological advancements by the R&D department that can help reduce the cost of production of a product are examples of the theory.
Drivers of the New Growth Theory
Instead of relying on uncontrollable external forces as the reason for a growing economy, NGT focuses on three key features as the means for a thriving economy.
1. Importance of knowledge: Knowledge is essential to NGT, as it views knowledge as not a commodity subject to diminishing returns.
Only through proper symmetrical knowledge can an individual or firm make well-informed decisions. Therefore, knowledge is treated as an asset because of its high importance.
- It's an asset that, if added on continuously, will keep on growing and provide more returns. If there is proper circulation of knowledge and a better understanding of the economy, informed consumers and potential investors start to develop whose decisions impact an economy.
- NGT focuses on moving away from extreme reliance on physical assets and expanding knowledge in the economies. Government and private enterprises are advised to focus on institutions that can help develop the knowledge base and share the same in the economy.
- Government should primarily focus on developing skills and human capital to drive the economy and support the private sector as well for the same. Further, attention should be put on inward investment to bring more knowledge into the economy.
2. Technology: Only through new innovative technology launched into the workplace can individuals and firms effectively generate profits.
Potential generated profit collectively impacts the economy as some of it is spent, and the rest is invested, which is later circulated in the economy.
3. Entrepreneurship: It's through the means of entrepreneurship that individuals pursue their wants and needs. It helps individuals have a sustained income that can provide for their necessities and generate profits from which they live easily for the rest of their lives.
The Role of the Public Sector
Public investment in social capital is subject to failure. Therefore, the NGT proponents argue that the government should allocate coffers to compensate for this failure.
1. Essential Services like electricity, gas, and water are natural monopolies (A monopoly is an exclusive possession or control over a commodity or service for trade in an economy.)
Further, numerous countries have these monopolies managed by the public sector. Still, if these services are under-supplied due to shy public finances, the private sector will suffer, and growth will be limited.
The artificial sector relies on water and energy for production and distribution to be competitive and efficient.
Primarily, this is because the artificial sector relies on energy and water for its product and distribution, without which it will not produce efficiently or competitively.
Thus the correct disposition of expenditure depends upon the accumulation of private capital by the government.
2. Also, New Growth proponents argue that the government should be attentive to developing rail, roads, and other structural systems like oceans and air transport by seeking finance, or seek finance for structure systems, since the development of these help in the flourishing of the private sector as well.
Some public goods might be undersupplied if provided without help from the government or if private enterprises invest in these goods, it might be too expensive for the middle and low class.
Since these goods and services require a substantial fixed cost and the difficulty of charging certain people causing, free riding prevents the private sector from supplying.
Free riding is when an individual benefits from the efforts or actions of another. For example: If an individual doesn't pay tax for a particular commodity like a Highway but still uses it, it's considered a free-riding problem.
3. The state can act like a patron and financier to give necessary legislation for and collaborate on similar systems. These systems also induce positive externalities and further justify government involvement.
For illustration, through an advanced structure, the liability of sightseer profit increases to an extent, and the production costs also fall.
An externality is the consequence of some commercial activity that affects other parties without being reflected in the market price.
The workers of factories and people living nearby suffer from deteriorating air quality, a negative externality. On the other hand, switching from conventional farming to organic farming, leading to a lower level of environmental chemicals, is an example of a positive externality.
Implications of NGT
In 1950 Robert Solow crafted the model that kept diminishing returns to factors like labor and capital but added in a third factor; technological knowledge.
This third factor continued to produce economic growth and productivity.
The reason for technological progress in this model is assumed to be determined by outside forces, i.e., an exogenous factor.
Solow viewed technology as an ever-expanding knowledge that would become evident over time.
Paul Romer, an American economist, is often associated with the NGT. It aims to provide a better explanation of growth factors and states productivity changes are affected by technological progress, which is affected by incentives like profits.
- Knowledge is a significant factor for any technological progress or innovation.
- Government contributes to knowledge by investing in developing skills, whereas firms contribute through research & development and technological transformation.
- According to research, capital gains per hour also lead to a rise in real GDP per hour.
- According to Romer, how people react to incentives affects any technological innovation. The more profit, the more complex people research to find the solution.
- Further, knowledge gives increasing returns at a macro level;
Romer believes it will provide diminishing returns at the firm level since they can only increase their pace to a critical level.
Once a new idea is discovered, all can use it, but physical goods cannot be accessible to everyone.
For example, Rival goods owned by a firm or individual can be either goods or services that the owner can prevent anyone from utilizing to generate competition and demand for the goods.
Romer believes technological progress is affected by the number of people seeking them and is not coincidental.
And if the economic incentive is strong enough, the attention will divert to human capital expansion, and similar innovations will be sought to achieve this goal.
Thus, Human capital is believed to be the most precious that the government and businesses should target to achieve economic prosperity.
Hence, higher importance is given to learning, skills development, and exposure to opportunities to engage in entrepreneurship, research, and development.
New Growth Theory vs. Neoclassical Economics
Again, NGT proposes that individual special forces are eventually the motorists of profitable progress and that fostering individual growth fosters profitable growth. The prevailing proposition to it was neoclassical economics.
1. Neoclassical economics was initially established by forward thinkers similar to Carl Menger, William Stanley Jevons, and Léon Walras.
At its commencement, neoclassical economics assumed that how valuable goods and services were to consumers versus the costs to produce and distribute the said goods and services was the primary factor driving profitable growth.
2. Neoclassical economics is a broad twist on classic economics, focusing on force and demand as the primary factors behind profitable growth. It argues that markets are competitive and, thus, usually reach the optimal level of allocation and production on their own.
Also, it implies that governments have limited opportunities to promote to meet economic ends. Most opportunities are limited to the encouragement of market competition, adequate schooling, and saving & investment.
3. Exogenous growth, a crucial tenet of neoclassical economics, considers many specific rudiments within businesses and husbandry that are the ultimate masterminds of profitable growth.
Among these rudiments are factors like Diminishing capital returns, product costs, the Rate of savings, and Technological variants like tools, programs, etc.
4. Neoclassical economics was further expanded when the production costs and other external factors proved to make a significant impact on the growth of an economy.
The Neoclassical model, however, does not explain what causes the increase in technological progress over time. Instead, it conceptualizes that changes in production are due to technological changes but doesn't state the reasons behind these changes or what drives such changes.
The new growth theory, however, explains the reasons for an increase in technological advancement: economic incentives. It argues that innovation is not due to a coincidence but rather the incentives of profit that drive people to research harder.
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