The Residual -- and Endogenous Innovation

In the middle of the twentieth century, economists' thinking about economic growth was dominated by the role of investment in increasing labor productivity. But these studies led to a rather negative conclusion. Where steady economic growth was observed, only a small part of it could be explained by investment. The part that could not be explained by investment was called "the residual," and it was increasingly clear that "the residual" was the larger and more important part of economic growth.

Neoclassical economists explained "the residual" by technological innovation, but innovation itself remained something of a mystery. Of course, technological innovation could be a result of investment in research and development, but then, investment in research and development is investment -- increasing the roundaboutness of production -- and if investment is subject to diminishing returns, that would include investment in research and development -- wouldn't it?

Neoclassical economic growth theory came to the conclusion that innovation is the basis of most economic growth, but innovation itself cannot be explained by economics. That may be right, but it isn't very satisfying and it isn't very useful.

It isn't satisfying:: We want to ask, can innovation really be continuous, and if so, how? How is this explained?
It isn't useful:: We want to put economic theory to work in figuring out how we can improve the standard of living, perhaps by speeding up the process of technical innovation. But the neoclassical theory doesn't tell us how to do that.

These concerns led, in the 1980's, to new versions of the "virtuous circle." Recall, Smith's optimism was based on a "virtuous circle" in which growth creates the opportunity for more growth. The new economic growth theorists of the 80's proposed a virtuous circle of innovation: growth in labor productivity might create the conditions for more profitable investment in research and development, which in turn leads to more productivity growth, to more innovation, and so on. In this way, we could explain how innovation can be continuous.

In this sort of growth theory, innovations are a result of economic events. Economists express this by saying they are "endogenous," so these theories are called "endogenous innovation" or "endogenous growth" theories. Research on this sort of theory is ongoing, and many details remain unsettled.