State of Innovation

Patents and Innovation Economics

Is Innovation the Key to Growing the U.S. Economy?

Traditional Explanation of Economic Growth

What causes economic growth?  One of the common explanations is consumer spending.  As a headline on Minnesota Public Radio’s website in October 30, 2008 stated “Consumer Spending Accounts for Two-Thirds of U.S. Economy.”  If consumer spending is such a big part of the economy, then all that is necessary to stimulate economic growth is to get consumers spending more.  The other one-third of the U.S. economy is government spending, so perhaps by having the government spend more money we can stimulate the economy.  The theory of spending causing economic growth is commonly associated with Keynesian economics. 

The multiplier effect is one of the more bizarre theories of consumption side economics.  The multiplier effect states that for each dollar of government spending, the private economy will spend three dollars.  More recent estimates are 1.2 to 1.5 depending on the type of spending.  One implication of this theory is if we want ten percent growth in the economy, the government just needs to spend enough money so the multiplier results in a 10% increase in the economy.  Therefore, if we want infinite growth, then the government just needs to spend an infinite amount of money.

Say’s Law of classical economics states that production creates its own demand.  Modern economists building on Say’s Law propose policies that encourage production.  As a result, they focus on low taxes, minimal government spending and incentives for companies and people to produce economic growth.  This school of thought focuses on the supply/production side of the economy.  A major tenet of supply side economics is the Laffer Curve.  The Laffer curve shows that when the marginal tax rate is too high it actually results in less tax revenue than a lower tax rate.  As a result, high marginal tax rates are often counter productive.

laffercurve Logically, supply side economics has a significant advantage over Keynesian economics because it is consistent with the reality of consumption and production.  In order to consume something, first one has to produce.  Imagine a self-sufficient corn farmer who consumes all his corn including his seed stock.  He has maximized his consumption, which should be good, according to Keynesian economics, but he has nothing to grow next year and will starve unless he finds another means to produce food.

Adam Smith and Growth

Adam Smith suggested three ways in which the annual output of a country could be increased.[1] One is an increase the population, second is the division of labor and third is “some addition and improvement to those machines and instruments which facilitate and abridge labor.”[2] An increase in the population or number of workers will increase the output of a nation but does not result in per capita economic growth.  This chapter is concerned with what causes per capita economic growth, which improves the life of the average person.  Why would the division of labor result in growth?  When each person focuses on their particular job, they are able to produce efficiencies that are unlikely to occur when they are a jack-of-all-trades.  Interestingly, our income tax discourages the division of labor.  Because of the income tax, many people will take on tasks in their personal lives that theoretically would be more economically performed by another person.  For instance, a homeowner might repair their washing machine rather than hire a repairman.  The after tax cost of hiring the repairman is more than they earn per hour.  Without income taxes, it would make more sense for the homeowner to hire the repairman and focus on their own profession.  However, there are limits to how efficient people can be in their jobs.  Finally, Adam Smith suggests an increase in capital goods and inventions will increase a nation output.

Innovation Economics

Modern economists have studied this issue and found that increases in capital goods are not nearly as likely to result in economic growth as innovation.[3] Robert Solow won the Nobel Prize in Economics because of his work on the causes of economic growth.  His model suggests that fourth fifths of the economic growth of the U.S. is the result of technological progress.

Real per capita increases in income can only be the result of innovation.  Adding capital without any innovation associated with the capital will result in elevating every worker to a certain efficiency level, however never above that level.  Once every worker has the all the capital resources they can use in their job they have hit a maximum output without innovation.

What if we had exactly the same technology now as we did in 1800?  Would we be any better off per capita than the people of 1800?  You might think that we would live longer.  But, why would we live longer.  We would have the same nutrition, sanitation, and medicine as them.  We would have no advantages over our ancestors if we were limited to their technology.  Our per capita income would be the same as the people of the 1800s.

Real per capita income growth is due to innovation.  This is consistent with classical economics and supply side economics but refines our understanding of growth.  The sad thing is, most college economics courses do not even discuss innovation.  These courses focus on static supply and demand curves.  Covering up the discussion of innovation with the Latin phrase “ceteris paribus” – all other things being equal.

The process of innovation, which Joseph Schumpeter called creative destruction, has largely been ignored by economics.  However, other economists who have worked on innovation economics, include Robert Solow, Paul Romer and Gregory Clark.  From a fundamental point of view in order to consume something it first has to be produced.  In order to produce something, it first has to be invented or discovered.


While inventions are the cause of per capita income growth, market feedback mechanisms are still necessary to determine what inventions should receive investment.  Without market feedback mechanisms, we might end up in the same position as the USSR.  They setout on a program to produce more steel than countries in the west in the 1950s and succeeded.  This caused many pundits in the west to suggest that communism was economically superior to western capitalism.  However, it turned out that much of the steel was not needed and therefore not production but waste.

The U.S. needs to adopt policies that encourage innovation.  However, these policies should be structured to work within our market economy.  Encouraging innovation that is not subject to market forces is likely to fail for the same reason that the USSR’s emphasis on production without market mechanisms failed.

Has U.S. innovation declined since 1990?  If so why has U.S. innovation slowed?

[1] O’Rouke, P.J., On the Wealth of Nations, Grove Press, 2007, p. 83.

[2] Smith, Adam, An Inquiry into the Nature and Causes of the Wealth of Nations, Edited by Edwin Cannan, New York, Modern Library, pp. 373-374.

[3] Clark, Gregory, A Farwell to Alms: A Brief Economic History of the World, Princeton University Press, 2007, p. 197.

July 8, 2009 - Posted by | -Economics, Innovation | , , , , ,


  1. “The after tax cost of hiring the repairman is more than they earn per hour”

    No, it’s no the tax that makes it so. It is the high cost of labor in the US. Any ideas on how to bring that down?

    Comment by Anon | August 13, 2009 | Reply

  2. Anon, the cost of labor in the US is due to a number of tax and other regulatory requirements. Even without these, the cost of labor is likely to be higher than most places, since the US employs more technology per worker on average. As a result, the average worker in the US is more productive than workers in almost any country in the world.

    Comment by dbhalling | August 13, 2009 | Reply

  3. “The multiplier effect is one of the more bizarre theories of consumption side economics”

    The same could be said of the Laffer Curve. Both theories are valid in extreme cases, but can only be extended so far.

    Your “logic” seems to be that the coin only has one side. You say it’s more logical to focus on supply-side because in order to consume something it first has to be produced. But of course, in order for something to be produced, the entrepreneur has to believe there’s a consumer willing and able to pay for it. We can keep playing this chicken and egg game, or we can simply realize that the coin has two sides, and both sides matter. Supply-side policies have followed a similar trajectory as Keynesian: 2-3 decades where they seemed effective, followed by a decade or two of relative economic stagnation.

    The effective tax rate on entrepreneurs is 15% (since entrepreneurs make their largest fortunes by building a company and selling it–or shares of it–which is subject to 15% cap gains rate). I don’t know where entrepreneurs could go where they’d find a work force as productive and educated as America’s, infrastructure as good as America’s, and a lower tax rate than 15%. I’m pretty sure such a place doesn’t exist (though it might be possible to do better on 2 of those 3 areas, but not all 3). The incentives are there…it’s the consumer that’s the problem. American consumers are heavily leveraged and have had stagnant wages for some time. We can keep beating the supply-side horse, or recognize that it’s a good idea that has simply run its course and it’s time to move on.

    Comment by Devin Martin | September 22, 2009 | Reply

  4. Devin, what you fail to recognize is that production has to proceed consumption. There are always people capable of consuming, even if they are incapable of producing. Say’s Law makes it clear that production will create consumption, but the opposite is not true. It is also important to note that innovation proceeds consumption logically. Stimulating consumption is like eating your seed corn. The most effective way to get the economy growing is to focus on policies that stimulate innovation.

    Since 2000 we have passed a number of laws and regulations that are killing innovation in the US. The incredible innovation of the 90s was based on technology start-up companies built on intellectual capital, financial capital, and human capital. All three of the pillars have been under attack since 2000. Our patent laws have been weakened reducing the value of intellectual capital. Sarbanes Oxley has made it impossible to go public reducing financial capital for start-ups and the FASB rules on stock options have made it harder to attract human capital to start-ups. For more information see

    Comment by dbhalling | September 22, 2009 | Reply

  5. Seriously? You’re basing your argument on the fact that in chronological order production precedes consumption? The production of a hamburger precedes my eating it, but the process wouldn’t have started if I hadn’t ordered a hamburger in the first place. (This is where chicken & egg comes in…I can’t order a burger without the owner building the restaurant…but the owner doesn’t build a restaurant if he doesn’t think people like me will order burgers…I could keep going but you don’t seem willing to imagine a world that exists prior to the cook grilling the burger.)

    That’s an interesting interpretation of Say’s Law you have. But even if I agreed with your interpretation, which I don’t (and neither did Say–he advocated public works to remedy unemployment), you still have to consider that Say’s Law is merely an economic model of behavior…and economic models–while useful–aren’t perfect, as we’ve all learned quite clearly lately.

    Finally, did you actually say SOX has made it impossible for companies to go public? Maybe you missed it, but there’s been hundreds of IPOs since SOX was established, including one of the world’s largest companies (a little website called Google that you’ve probably heard of). While those numbers are down from the late 90’s, most experts consider that a good thing. Let’s face it, most of the IPOs in the late 90’s were nothing but a big dream and an eager VC. The fact is, you make some good points in your article, but you destroy your credibility by making foolish ideological statements.

    Comment by Devin Martin | September 22, 2009 | Reply

  6. Order matters in logic, economics, and the real world. As pointed out in my post, if a farmer were to follow spending-side recommendations he would eat all his seed corn to maximize demand. However, this would mean that he would starve the next year. Investment, production, and innovation have to proceed spending. The only reason your order for a hamburger has any value is if you are productive (able to pay for the hamburger). Spending does not create production, unless it is proceed by production. There is always an unlimited amount of demand if the price is reduced to zero. Spending-side economics results in wasteful production, because it is not based on demand by productive entities.

    No Silicon Valley VC companies went public in the 2nd quarter of 2008 an event that has not happened since 1978. The recent update is that there were no Silicon Valley start-ups that went public in 4th quarter of 2008 or in the 1st quarter of 2009. Numerous companies went private after SOX was passed. Access to the public markets is absolutely essential for American innovation. The so-called experts you mention ignore that their policies have lead to the worst recession since the Great Depression, while the downturn at the end of the 90s was very mild. Their policies have killed off innovation in the US. Even the Obama administration admits that access to public markets is key to innovation, see A Strategy for American Innovation: Driving Towards Sustainable Growth and Quality Jobs. (

    The present downturn was not due to a lack of spending, it was due to a lack of innovation.

    Comment by dbhalling | September 22, 2009 | Reply

  7. Yeah, I’m sure more IPOs is exactly what this economy needs :-)

    I don’t think SOX is the only reason there were no IPOs in 4q08. It may have contributed, but there were quite a few things going on in the world of finance that *might* have been more influential than SOX.

    BTW, thanks for demonstrating my point that the consumer matters. Obviously if consumers have no income, there’s no incentive for producers to produce. Henry Ford realized this.

    And I can’t help but notice you mentioned the 90s tech boom as a major innovative force. That’s funny, because the 90s tech boom was preceded by decades of government investment in DARPAnet/Internet and microprocessor technology. Personally, I think if govt hadn’t laid the foundation for the Internet and massively invested in microprocessors to bring them to commercial viability, then you don’t get a tech boom in the 90s. One of the major roles the government plays in encouraging innovation is paying for new technologies. That seemed to go by the wayside during the 80s (when Reagan famously put an end to renewable energy funding by tearing solar panels off the roof of the white house) when supply-side was so in vogue.

    It’s a complicated world. Incentivizing productivity matters. But the ways government can encourage productivity are very diverse. Sometimes (as in microprocessors) that best thing government can do is buy new and expensive technology in the hope economies of scale make it cheap (worked amazingly well for microprocessors). That doesn’t really mesh with the supply-side theory I’m familiar with.

    Economies are complicated.

    Comment by Devin Martin | September 22, 2009 | Reply

  8. Devin, the world is not that complicated. According to your theory, we should go out and break everyone’s window. This would stimulate demand and consumption. Alternatively we should celebrate counterfeiters, they stimulate consumption. None of these are economic productive and they are exactly what spending-side economics suggests. Innovation is the only way to increase real per capita incomes. Robert Solow received the Nobel Prize in economic for this insight.

    Yes, the government can occasionally play a role in stimulating innovation. ARAPANET that you point is a good example. An older example was the using “American System of Manufacturing” to produce muskets. The Regan administration also encourage innovation, by supporting star wars. There are now companies using positrons for non-destructive testing. This work was advanced due to star wars as were some of the advances in ARAPANET.

    Comment by dbhalling | September 23, 2009 | Reply

  9. […] growth of the U.S. is due to increases in technology.  For more information on this see “Is Innovation the Key to Growing the U.S. Economy?”   The government’s antitrust action erased the value of research and development and […]

    Pingback by Jobs, the Economy and Patents « State of Innovation | October 21, 2009 | Reply

  10. […] Surely, you are not suggesting that the reason for the stagnation of median income and the economy are due to the stagnant number of patents?  How do you know that the cause for the stagnation in the number of patents is not the result of the poor economic performance?  While I am not suggesting an exact one-to-one correspondence, yes, these phenomena are linked.  Based on modern economics we know lack of innovation is the cause of the economic and per capita income stagnation.  Robert Solow won the Noble Prize in economics for showing that the major determinant for increased productivity is innovation.  This demonstrates that the cause is lack of innovation and the result is economic and income stagnation.  For more information see: Is Innovation the Key to Growing the U.S. Economy. […]

    Pingback by Foreigners Receive More Patents than U.S.! « State of Innovation | November 9, 2009 | Reply

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