There is a Free Lunch – New Growth Theory

Another gloomy week passes by, with no resolution for the deficit crisis.  There’s talk of a potential downgrade to the US credit rating, with subsequent increases in interest rates.  The stock market reacted harshly, with the Dow Jones Industrials off approximately 400 points.  Is there any reason to be optimistic about our economic future?  In this week’s post, I’ll explore a little known economic theory that gives us reason for hope.

New Growth Theory is an idea that has gained attention from the economic community over the past 25 years.  Its biggest current advocate is the economist  and public intellectual, Paul Romer.  Traditionally, economists looked at additions of capital and labor as the primary drivers of growth and productivity.  Unfortunately, these drivers were limited by the law of diminishing returns.  For example, a warehouse using entirely manual labor could add a forklift to make their operation more efficient.  It’s possible that they would see additional gains in efficiency by adding several more forklifts.  At some point they would get minimal additional benefits from adding the nth forklift.

In contrast to traditional economic theories, New Growth Theory posits that knowledge and ideas are a dramatic and inexhaustible source of productivity gains.  The core idea behind New Growth Theory is the concept of rivalry.  Physical objects such as machines, tools or people can only be used for a single task at a given point in time.  Romer would describe these objects as rivalrous.  Knowledge or ideas can be used simultaneously for an unlimited number of tasks, at no additional cost.  Romer calls this type of growth input non-rivalrous.

Let’s go back to our forklift example.  A forklift requires a specific capital investment.  It has a specific capacity and can provide a limited amount of productivity to a warehouse.  If you want to increase the capacity you need to make the additional investment for another forklift.  It is a rivalrous good, that can only be used for one purpose at a given point in time.

Let’s contrast this to an idea, or better way of doing something.  Imagine the same firm that owns the warehouse has come up with a better way of organizing goods in its warehouses.  The idea allows any forklift to be 3x more efficient.  That idea can be shared with multiple warehouses at no additional cost.  Ultimately, it could spread as an industry best practice, used by tens of thousands of warehouses globally.

Non-rivalrous goods exist across the entire idea spectrum.  They range from a major finding in “Big Science” to a simple improvement in a process in a retail store.  Anything that can be replicated at minimal cost, used simultaneously and improves productivity is a non-rivalrous good.  One of the best examples of non-rivalry is software.  Once the initial investment is made to develop a software product, it can be reproduced at near zero marginal cost.

So if it’s all so simple and obvious, why don’t more firms exploit the clear advantages of non-rivalrous goods?  Several factors have been at work, limiting the adoption of New Growth ideas.  First, software companies have typically been the beneficiaries of non-rivalry.  In traditional proprietary software models, enterprises had to pay significant incremental fees to deploy additional software, despite the marginal costs being negligible.  Second, companies have typically been loathe to share best practices with rivals for competitive reasons.  Therefore, many ideas and process improvements have stayed inside the “four walls” of a given enterprise.  Third, traditional enterprises did not broadly encourage idea generation and process improvements.  As much as most firms tout the concept of “working smarter”, they have typically limited these activities to management consultants or designated process improvement teams.  The vast majority of other employees within a firm are “heads down” on simply performing their designated functions.

So why should we feel encouraged that New Growth Theory is a reason for optimism in these uncertain economic times?  First, trends towards open-source can reestablish software as an effective non-rivalrous good.   Second, the widespread adoption of social media, both publicly and within enterprises, can allow for rapid spread of innovations, process improvements and knowledge.  Finally, new, progressive management ideas, championed by such firms as Google, and academics such as Gary Hamel, have started to gain traction in the corporate world.

Forward thinking enterprises that want to leverage the virtues of New Growth Theory should consider the following actions:

  • It all starts with culture.  Establish and nurture a culture where new ideas and knowledge sharing are paramount.  Ensure that all employees have dedicated R&D time, where they are able to come up with new product ideas or process improvements.  Establish job descriptions and compensation practices that reward team members for generating new ideas and assisting others.
  • Social Media is the key tool that enables the sharing and spreading of new ideas.  Ensure that your firm has a stated direction and policies that encourage the use of social media, both inside and outside the enterprise.
  • Open-source software, virtualized hardware and software as a service (SaaS) have the properties of non-rivalrous goods.  They allow for significant gains in productivity without significant marginal investments.  They should be central pieces of a firm’s productivity improvement strategy.
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