As usual with our Fridays Academy, based on Raj Nallari  and Breda Griffith's lecture notes.
Spending on Research and Development
Production function of each country may be different depending upon differences in diffusion of technology, infrastructure stock and human capital, and natural resource endowment. Theoretically, it is possible for a country to experience growth for a long period of time even if there is no technological progress merely by continuously accumulating physical and human capital. However, innovations are endogenous to firms and economy due to large spending on R & D (which maybe distorted by tax credits that encourage firms to classify current expenditures as investment) and variations in incentives facing innovators.
If technology is broadly defined as differences in productivity across countries, then this explains much of the disparities in per capital income across countries (De Long 1996). On the other hand, if technology is defined as most modern machinery and manufacturing processes, then this explains little of the differences in per capita income across countries. For example, Clark (1987) shows that during early twentieth century different textile mills across countries used the same machinery but there were large differences in output per hour. Similarly, why is Japan 47% more productive than USA in steel production but 67% less productive in food processing (McKinsey 1993).
Recent endogenous growth theories emphasize technological change to be endogenous to explain growth patterns amongst countries of the world. Innovations and inventions happen because of expenditures undertaken in research and development (R&D) sectors, which uses human capital and the existing knowledge stock. It is then used in the production of final goods and leads to permanent increases in the growth rate of output. Data available on 20 OECD and non-OECD countries indicate that innovation has a positive effect on per capita outputs of both developed and developing countries. However, only the large market OECD countries are able to increase their innovation by investing in R&D (that is market size is important) and the remaining OECD countries seem to promote their innovation by using the know-how of other OECD countries. In particular, a 1 percent increase in innovation raises per capita income by around 0.05 percent in both OECD and non-OECD countries, while a 1 percent increase in R&D stock increases innovation by about 0.2 percent only in large market OECD countries, which includes the G-7. This implies that innovation, like capital stock, leads to only short term increases in the growth rate of output, and is not able to explain perpetual economic growth. However, as neither patent nor R&D data are complete measures of innovation, these results should be interpreted cautiously.
In both advanced and emerging economies, government is large source of financing for research, universities, think tanks etc. Social rate of return to innovation is substantial, which means that governments should provide modest incentives for R & D only for leading industries and not for traditional or declining industries or sectors. Also, links between public financed R & D spending and private industries should be encouraged, where strategic technology (e.g. nuclear technology) is not an issue. How strong is the causality between research activity and innovation? Would growth lead to higher R &D and therefore technological change or is it vice versa? Is innovation more dependent on good luck of technological opportunities than on incentives and spending on research and development? A lot of research is still needed to answer these questions.
Next Friday: Technology Diffusion and Adoption
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