Philippe Aghion, Ufuk Akcigit, Peter Howitt,
Chapter 1 – What Do We Learn From Schumpeterian Growth Theory?,
Editor(s): Philippe Aghion, Steven N. Durlauf,
Handbook of Economic Growth,
Elsevier,
Volume 2,
2014,
Pages 515-563,
ISSN 1574-0684,
ISBN 9780444535467,
https://doi.org/10.1016/B978-0-444-53540-5.00001-X.

Schumpeterian Growth: Basic Model

This model is about how an economy grows when new inventions and innovations happen. It’s based on the idea that new innovations come from entrepreneurs who want to make a lot of money by creating something new and better. These innovations replace old ways of doing things, which is why we call it “creative destruction.”
• Time in this model is always moving, and there are lots of people in the economy. They all work and have money preferences. They care about the future but not too much.

• People have one unit of work to do for every unit of time, and they can use this time either to make things or to do research. They’re okay with doing either one.

• There’s a final product that everyone wants, and it’s made by using something called an “intermediate input.” This intermediate input can be of different qualities, from not very good (0) to excellent (1).

• The intermediate input is made by people working with their labor. If you put in one unit of labor, you get one unit of intermediate input, and the quality of what you make depends on how good you are at it.

• In this model, the economy grows when someone comes up with a new and better way of making the intermediate input. For example, if the best we had before was a quality of 0.5, someone might come up with a quality of 0.6, and that’s an innovation.

• When there’s an innovation, the new and better way takes over the market, and the old way goes away. This is why it’s called “creative destruction.”

• The model also says that innovations happen when people spend time doing research, and they happen at a certain rate.

So, in simple terms, this model is all about how new and better things are invented, which makes the economy grow. It’s like when someone comes up with a better smartphone, and everyone starts buying that one instead of the older ones. This keeps the economy moving forward.

The Research Arbitrage and Labor Market Clearing Equations
• Labor Market Clearing Equation (L): This equation talks about how all the work that people do is split between making things and doing research. It’s like deciding how much of your time you spend working on stuff we already know about and how much time you spend trying to come up with new ideas.

• Research-Arbitrage Equation (R): This equation is about a person deciding if they should work on making things (like a job) or do research (trying to discover new things). It says that the decision depends on how much they can earn from their job right now and how likely they are to discover something new through research.

• Bellman Equation: This one is a bit tricky. It’s like saying that when a company makes money, it has to think about the risk that someone else might come along and do the same thing better. So, the value of their innovation is their current profits minus the risk of being replaced by someone else.

Equilibrium profits, aggregate R&D and growth
In simple terms, these equations are all about how people and companies decide what work to do and how valuable their work is, considering the risks involved. It’s like figuring out whether it’s better to work at a regular job or try to invent something new, taking into account how much you can earn and the chances of someone else doing the same thing.
Growth Meets IO (Industrial Organization):

Some studies have shown that there’s a connection between economic growth (how well an economy is doing) and how competitive the markets are where companies sell their products.

People who give advice about economic policies often think that more competition (when many companies compete in a market) is a good thing for economic growth.

However, some economic models that existed before couldn’t explain why competition would lead to more growth because they assumed either perfect competition (everyone competes equally) or that more competition would lead to less innovation.

On the other hand, there’s a different type of economic theory called “Schumpeterian growth” that can explain why more competition can lead to more growth. It also explains some interesting things about competition and growth that other theories can’t.

Three important things this theory explains are:

• When companies have to compete a lot, especially if they are already very advanced in their technology, they tend to innovate more and grow faster.

• The relationship between competition and growth is like a curve. Starting from a low level of competition, more competition helps growth. But when competition is already very high, adding even more competition might not help or could even slow down growth.

• Having strong rules to protect patents (the rights to new inventions) along with competition encourages companies to invest in research and develop new things.

Understanding how competition and growth are connected also helps us understand how trade (buying and selling goods with other countries) affects a country’s growth. There are two main effects:
• When a country opens up to more trade, it gives companies a bigger market for their products. This makes them want to create new things, which is good for growth. This part is explained by many growth models.

• The Schumpeterian model also says that when a country opens up to trade, it brings more competition, which can encourage innovation and growth. This part helps explain why some countries that opened up to trade saw more economic growth.

In simple terms, this text is all about how competition and trade can affect a country’s growth. It tells us that having more competition can sometimes be good for innovation and growth, but there’s a balance, and too much competition might not be so good. It also talks about how trade can help a country’s growth, especially when it encourages companies to come up with new ideas and products.

The Argument:

We’re trying to understand how competition affects innovation and growth in an economy.
Before, we thought that new, better ideas always come from outside the established companies.

Now, we’re considering that sometimes, companies have to catch up with the leaders in their industry before they can become leaders themselves.

This “catching up” might happen because the leader knows something special (we call it “tacit knowledge”) that others can’t copy without doing their own research.
So, in some industries, companies might be closely competing (like in a race), and more competition makes them work harder to come up with new ideas (the “escape-competition effect”).

But in other industries, where one company is way ahead, more competition might discourage innovation because they’re more focused on making short-term profits by catching up (the “Schumpeterian effect”).

The overall mix of these types of industries in the economy affects how competition influences growth.

Household:

People in the economy work in two ways: making things and doing research.
Each person wants to have a balanced life between work and enjoyment.
They spend money on the things they enjoy, and their spending has to match what’s being produced in the economy.

A Multi-Sector Production Function:

Instead of just one thing being made, we’re now looking at many different things being produced.

Each thing is made with different parts, and there are many companies making these parts.

Companies are grouped into pairs (duopolies), and they work together to make these parts.

They try to be efficient and make the final product as cheaply as possible.

Technology and Innovation:

Each company has its own level of technology and can make things more efficiently if it’s ahead.
Companies can try to get ahead by spending time and effort on research and development (R&D).

But if one company is ahead, the other can copy their technology and stay close in terms of how good their products are.

So, there are two types of industries: those where companies are closely matched (like in a race) and those where one is clearly better.

The leader in an industry can improve its technology by spending effort, and there’s a chance the follower can catch up just by copying.

All this is about how different industries in the economy work and how they innovate.

In simple terms, we’re looking at how competition influences innovation and growth in different industries. Some industries are like a tight race, where more competition encourages companies to invent new things. Others are not so close, and more competition might not help as much. It’s like thinking about how different sports affect athletes’ training and performance.

Equilibrium Profits and Competition in Leveled and Unleveled Sectors:

We’re looking at how much money companies make in two types of industries: leveled and unleveled.

In unleveled industries, where one company is way ahead of the other, the leader makes a profit, but the follower can’t compete and earns nothing.

In leveled industries, where companies are closely matched, if they compete freely, they both make very little profit, but if they work together (collude), they can make more money.

We use a measure called “competition” to see how much they can collude. If it’s high, they can work together well; if it’s low, they don’t.

So, the amount of money companies make depends on how they compete in these different industries.

The Schumpeterian and Escape–Competition Effects:

We want to understand how competition affects innovation and growth in the economy.

When companies compete closely (like in leveled sectors), they tend to innovate more if they can escape from too much competition.

In industries where one company is way ahead (unleveled), competition can sometimes discourage innovation, especially if the laggard company is more focused on catching up quickly for short-term profits.

Whether competition helps or hinders innovation depends on the situation in each sector.

If there’s more competition, innovation might go up in some cases and down in others, and it’s all about finding the right balance.

Composition Effect and the Inverted U:

Some sectors are always closely matched (leveled), and some are not.

Over time, some sectors change from being closely matched to not, and vice versa.

The overall rate of innovation in the economy depends on how many sectors are closely matched.

If there’s very little competition to begin with, more competition can lead to faster innovation because companies want to escape competition.

But if there’s already a lot of competition, adding more might slow down innovation because companies don’t feel the need to innovate as much.

So, the effect of competition on innovation can look like an “inverted U” shape, going up and then down as competition increases.

Overall Growth:

The economy’s growth rate is tied to how fast companies innovate.

When more sectors are closely matched, there’s more innovation, and the economy grows faster.

But if most sectors are already closely matched, adding more competition might slow down growth because companies aren’t as motivated to innovate.

In simpler terms, this text is all about how competition affects how much money companies make, how they innovate, and how fast the economy grows. Sometimes, more competition can be good for innovation and growth, but there’s a limit, and too much competition might not help as much. It’s like thinking about how different sports teams perform when they face strong or weak opponents.

Predictions

Prediction 1: Imagine there’s a balance between competition among companies and their ability to come up with new ideas (innovation). This prediction says that this balance is like a hill. At first, when there’s a bit more competition, companies become more innovative. But if there’s too much competition, it actually makes it harder for them to be innovative. This also means that when there’s a lot of competition, the difference in how advanced companies are (technological gap) within an industry becomes bigger.

Prediction 2: This one is about how different types of companies react to competition. It says that when there’s a lot of competition, companies that are already doing really well (called “frontier” firms) tend to come up with more new ideas. But for companies that aren’t doing so well (called “non-frontier” firms), too much competition can stop them from being innovative.

Prediction 3: This prediction talks about two things: competition and patent protection (which is like a legal right for inventions). It suggests that both competition and patents can help companies make more money when they create something new. This is different from what some people believed before. Some thought that competition and patents don’t work well together, but this prediction says they can actually help each other. It’s like saying two things that people thought didn’t go together can actually be a good team.

The main idea behind all of these predictions is to understand how competition, innovation, and rules like patents affect how companies grow and create new things. It’s like figuring out how different pieces of a puzzle fit together to make a bigger picture.

Predictions through the model

Prediction 1: This prediction talks about how big or small companies are in an economy. In this model, they measure a company’s size by how many different products it makes. So, some companies make many products, while others make just one. This prediction suggests that in real life, you’ll notice that most companies make only a few products, and only a few companies make many different products. It’s like saying there are a few giants, and lots of smaller businesses.

Prediction 2: This one is about the connection between how old a company is and how big it is. In the model, companies start small when they’re born and get bigger as they become more successful. So, naturally, older companies tend to be bigger because they’ve had more time to grow. In real life, you often see that older companies are larger.

Prediction 3: This prediction is about small companies. It says that smaller companies are more likely to go out of business, but if they survive, they tend to grow faster than average. In the model, small companies can disappear if they don’t come up with new ideas or products. But if they do well and don’t disappear, they tend to grow quickly. This is something observed in real life too.

Prediction 4: This one talks about research and development (R&D), which is like a company’s way of coming up with new ideas and inventions. It says that a lot of this R&D work is done by big, well-established companies. In the real world, big companies often focus on improving existing things, while small, new companies try to invent brand-new stuff. This prediction matches what we see in reality.

Prediction 5: Finally, this prediction is about innovation and where it comes from. It says that both big, old companies (incumbents) and new, small ones (entrants) come up with new ideas and inventions. In this model, the growth and progress of an economy come from companies changing and improving, with some new ones starting, and some old ones stopping. This is how an economy becomes more productive and innovative. In real life, we see that innovation comes from both new startups and established companies, and the movement of resources (like people and money) between them is a big reason why an economy grows and improves.

These predictions help us understand how businesses work, how they grow, and how they contribute to the overall development of a country’s economy. It’s like a way to explain why we see certain patterns in the business world.

Implications for countries

In this section, they are talking about how economic growth (making the economy bigger) and economic development (making it better for people) are connected. They suggest that what helps a country grow and become richer can be different depending on how technologically advanced the country is. For example, in more advanced countries, having a democratic system might be more important for growth.

Innovation Versus Imitation and the Notion of Appropriate Institutions

Here, they talk about how new ideas and inventions in one place can help other places grow too. They call this “technology spillover.” Basically, if one country figures out something new, other countries can learn from it and grow faster. They say that the kind of rules and systems a country needs (institutions) can be different depending on whether they are trying to come up with new ideas (innovation) or just copy what others are doing (imitation).

Further Evidence on Appropriate Growth Policies and Institutions

They provide some evidence to support their ideas. They talk about how in some countries, being open to trade (letting goods come in and out easily) helps growth, but in others, it doesn’t matter as much. They also mention that how easy it is for new companies to start (low entry barriers) is important for growth, especially in countries that are close to the technological frontier (meaning they are advanced).

In which countries does trade help innovation?

Trade can help innovation more in countries that are closer to the technological frontier. The “technological frontier” refers to the most advanced level of technology and productivity that exists in the world. Think of it as the cutting edge of what’s possible. In countries that are already very advanced (close to this frontier), trade helps them because they can learn from other advanced countries and innovate further. In simpler terms, if you’re already at the forefront of technology, trading with other advanced countries can help you stay ahead.

Is democracy always helpful?

Democracy, which means people have a say in how their country is run, is generally seen as helpful for economic growth. It encourages competition and innovation because it makes it harder for powerful businesses to prevent new ones from entering the market. However, this doesn’t mean democracy is equally helpful everywhere. The impact of democracy on growth can vary depending on how advanced a country is. In more advanced countries, democracy tends to have a stronger positive effect on growth because these countries rely more on innovation to grow.

Political Economy of Creative Destruction

Now they are talking about democracy and how it affects growth. They say that democracy can encourage innovation because it makes it harder for big companies to stop new companies from competing. They suggest that in countries closer to the technological frontier, democracy is more likely to lead to growth because those countries rely more on innovation.

So, in simpler terms, this section is about how different factors like democracy, openness to trade, and the ease of starting new businesses affect a country’s economic growth, and how these factors matter more or less depending on how advanced the country is technologically.

Does democracy always encourage innovation?

Democracy can encourage innovation, but its impact depends on how advanced a country is. In countries closer to the technological frontier (more advanced), democracy tends to have a more positive effect on innovation and growth. This is because democracy makes it harder for established businesses to block new innovators or prevent competition through political influence or bribes. So, in these advanced countries, democracy is more likely to lead to innovation and growth.

Schumpeterian Waves

This section talks about what causes long-term changes in economic growth rates and mentions something called “Kondratieff cycles,” which are long economic cycles. It focuses on why the United States’ economy started growing faster in the mid-1990s. The main idea here is the concept of “general-purpose technologies” (GPTs).

What are GPTs?

GPTs are new technologies that can be used in many different parts of the economy. Imagine them as game-changing inventions like the steam engine, electricity, or the computer. They are unique because they:

Affect many industries in the economy.
Improve over time, getting better and more useful.
Make it easier to create new things or processes (innovations).
However, when a GPT is introduced, it can lead to some temporary economic ups and downs as businesses need to adjust to these new technologies.

Why do GPTs matter?

GPTs are important because they bring about major changes in how businesses and industries work. When a new GPT comes along, it often replaces older technologies across different sectors of the economy, and this process can be disruptive.

Back to the Basic Schumpeterian Model

Key Points:
• People can either do research or work in industries.

• New technologies (GPTs) are discovered over time.

• When a new technology arrives, it increases productivity (makes things better), but it can also lead to temporary economic slowdowns.

A Model of Growth with GPTs

This part builds on the previous model by adding more details.

There are two stages in the economy when GPTs are discovered: research and manufacturing.

Each GPT leads to a cycle, and during the first stage (research), people figure out how to use it.

The arrival of a new GPT causes a rise in productivity but can also lead to temporary economic slowdowns.

GPT and Wage Inequality

This section talks about how GPTs can affect wage inequality, which is the difference in wages between different groups of workers.

GPTs can increase the gap in wages between skilled and unskilled workers.

The arrival of new GPTs can make skilled workers more in demand.

This can lead to higher wage inequality, even within groups of skilled or unskilled workers.

Predictions
Key Predictions:

• More new businesses (firm entry and exit) when GPTs are introduced.

• An initial slowdown in productivity growth when a new GPT arrives.

• Increase in wage inequality, especially between skilled and unskilled workers.

So, in simpler terms, this section is all about how big technological changes (like the internet and computers) can have both good and challenging effects on the economy and people’s wages

Conclusion
Unique Growth Theory: The paper has been talking about a special kind of growth theory called “Schumpeterian growth theory.”
This theory is different from other theories because it focuses on how new innovations and technologies impact the economy.

Connecting Growth and Firms: Schumpeterian growth theory helps us understand not only how the economy grows but also how businesses (firms) operate and how they affect this growth. It looks at things like new businesses entering the market, existing businesses closing down, and how resources are used by these firms.

Linking Growth and Development: The theory also helps us connect economic growth with the development of a country or region. It suggests that what works for an advanced economy might not be the same for a less developed one. For instance, it mentions that democracy can be more helpful for growth in advanced economies, while in less developed ones, other factors might matter more.

Useful for Policy: Schumpeterian growth theory can be used as a tool to design policies for economic growth. It suggests that different countries or regions might need different policies based on their unique situations. For example, it might recommend more competition in some places, more openness to trade, or more investment in research and education.

Understanding Economic Effects: The theory helps us understand how different economic factors, like competition, investments, and incentives, interact with each other. It explains that sometimes these factors can work against each other, and the theory helps us figure out when one factor is more important than the others.

Future Directions:

The paper also discusses where researchers might focus their attention in the future:

Study of Firms and Research: Researchers are interested in understanding how the way companies are organized and how they do research affects innovation and growth. This includes looking at the size and structure of companies, which can depend on things like the availability of skilled workers and local rules.

Developing Economies: Research will also explore how growth, firm behavior, and changes in businesses happen in developing countries. Some studies have shown that these countries often have inefficient resource use, and Schumpeterian theory can help explain why this happens and how to fix it.

Role of Finance: Understanding how different types of financial tools (like stocks or loans) relate to different types of growth and innovation is another area of interest. Additionally, researchers want to learn why there’s a lot of financial activity when new technologies are spreading and how financial sectors change when these technologies become less new.