New goods, old theory and the welfare costs of trade restrictions

1. New goods, old theory and the welfare costs of trade restrictions A paper by Paul Romer (Journal of Development Economics 1994)

2. ‚New Growth Theory‘: The Economic Theory of the Knowledge Economy • David Warsh: Knowledge and the Wealth of Nations (2006) • Endogenous Technological Change (1990): Knowledge as a non-rival, partly-exclusive good (in addition to capital, labor and land). Expensive to produce, easy to copy ► Intellectual Property Rights/ Innovation Policy • ‚New Growth Theory‘ vs. ‚OId Welfare Economics‘ • Time lag in Europe: where is Paul Romer?

3. New Goods Economists do not know because economic theory is based on the philosophy of plentitude „everything that could possibly exist already exists“ (A. O. Lovejoy, The Great Chain of Being, Cambridge, 1936). New goods and technologies are taken as exogenous (produced by science and business) – yet they are part of the economy • How do they come into being? • What is the welfare impact of new goods? • New goods may be the hidden source of welfare (more choice, • more employment, more choice, more efficient use of resources) • comparative-static models in economics do not show them • – but empirical research of economic history clearly does • ►Countries that do not benefit from ‚new goods‘ are • affected by welfare losses that exceed those calculated by • trade economists

4. Neoclassical General Equilibrium Analysisin a market with two goods/time periods and a given budget • Choice can be between • - apples and oranges today (present product choice) • apples today and apples tomorrow (intertemporal) Good Y Good Y Utility Preference Curve (PC) ► Convexities do not allow for the possibility that many valuable new goods could be produced Pareto optimum Transformation Curve (TC) Good X

5. General Equilibrium Analysisin a market where only one good exists…yet Asserting that a new good could be introduced is equivalent to asserting that the economy is currently on the boundary or edge of the goods space (problem of convexity assumptions). Good S No amount of good S is produced because no amount would be worth the cost in foregone units of good X that it would take to produce any of good S. If there is a third good Y that is already posivitely produced we get the old equilibrium Always at the edge of the goods space Production of Good S=0, Good X=x1 Good X x1

6. General Equilibrium Analysisin a market where new goods are produced at the fixed cost of x1- x2 units of good X Out of an enormous set of possible new goods S, one (Z) is selected and introduced in the economy because the expected benefits exceed the fixed costs of bringing them into the market. ► monopolistic competition rather than perfect competition (perfect competition does not allow anyone to invest in a new product) Good Z z2 R&D fixed costs/ physical fixed costs (e.g. a new design)/ (e.g. a new bridge) s1 Good X x2 x1

7. Partial Equilibrium Analysis and New GoodsTrade/Monopolist Policy Price Z (measured in units of output Z) A? general welfare surplus Dupuit Triangle Deadweight loss for consumers/ producers (Deadweight Triangle) A P Tax Rent B C Marginal Cost (MC) P* Demand (derived from production process = marginal utility schedule) D E F Good Z z1 z2

8. Dupuit (A) versus Deadweight Triangle (C) • Jules Dupuit, an 19th century engineer in France, developed a project analysis for goods that did not yet exist (e.g. bridge). • Basic assumption: the maximum net revenue that could be collected by simple monopoly pricing is less than the total social value created by the bridge (monopolist can capture B+D but not A in the graph, which is today called the Dupuit triangle • Hotelling (1938): bridges should be built by governments because • of the large fixed costs and the risk of welfare loss due to monopolist • bridge tolls (deadweight triangle) ► neoclassical welfare economics Deadweight triangle and the associated welfare losses became associated with market failure and a justification of government intervention (yet state monopolies may care less about O&M and do not respect the user-pays principle (free rider problem) • Harberger (1954): the magnitude of the welfare losses by monopoly • practices and trade restrictions is small (deadweight triangle)

9. Puzzle in the Developing World Some countries opened their economies significantly but remained very poor, others impose high tariffs on certain goods but have grown wealthy over the past three decades. Why? E.g. Entrepreneur wants to build a bridge in a developing country - as long as revenues are expected to exceed costs (extracting a rent to make up for the fixed costs). Price to cross the bridge If government profit-tax exceeds monopoly rent, the bridge will not be built. The same applies to bribes, expropriation risk, trade restrictions of capital goods/skilled labor, content requirements, bureaucratic hurdles. x A P Tax Rent MC (marginal costs) B C P* Tax exemptions/availability of human capital/infrastructure deep financial markets (hedging) D E F Good Z (Bridge) z2 z1

10. The principle of plentitude If we assume that there is just one Universe, it will still be fine as a working hypothesis (the influence of other possible Universes on our lives is marginal). But if we assume that the global economy is limited to the production of already existing goods, then this is totally inadequate to explain reality because we are confronted daily with new goods that become available (exponential growth of knowledge exponentially increases the probability of new goods and technologies emerging) The more new goods and technologies the global economy produces, the more fatal become trade restrictions for knowledge/goods/technologies (growing inequality).

11. Conclusions Government intervention that increases the cost of doing business (e.g. by heavily taxing profits of foreign investment) can have very large negative effects on aggregate output and social welfare because of all the lost ‚Dupuit triangles‘). It may matter more for small than big economies (scale advantage may prevail). The production of new goods is at the heart of a market economy. Yet, welfare economics still assumes that no new goods come into existence. This may also be a reason why neoclassical economists are not really good at explaining the social benefits of globalization. New Growth Theory, the theory of the new knowledge economy, is likely to cause a shift of paradigm in economics since it is better able to explain a real world. However all the economists that have jobs in Government to manage ‚market failure‘ will resist (especially agricultural economists)

12. Partial Equilibrium Analysis and New GoodsTrade/Monopolist Policy Price Z (measured in units of output Z) good Z is a capital good to produce good X MC= Opportunity cost in units per output good X, diverted to produce good Z A? general welfare surplus? z2*p=B+D (but what about A?) Good X Deadweight loss for consumers/ producers A P Tax Rent B C Marginal Cost (MC) P* Demand (derived from production process = marginal utility schedule) D E F Good Z z z1 Price X (units in the output of X) (must be brought into existence) (exists already)