TP2 Economic Foundations

Question 1

Sources of economic growth (Aggregate production function)

Answer 1

GDP=A(K, L, Anything else)
A=Technology
K=Physical Capital
L=Labour

Question 2

Neoclassical (Exogenous) Growth theory, Solow (Swan) theory

Answer 2

*You get decreasing returns to any single factor of the production function.
*Constant returns if all input factors remain in the same proportion.
*Due to decreasing marginal returns, capital-poor countries will grow faster, and there should be convergence in long-run income levels.
*High population growth will lead to low level of income per capita
*Investment rate (growth rate of capital) is a key determinant of national wealth
*Decreasing MP produces convergence.
*Only technological progress can explain persistent increase in per capita growth - and this is exogenous (To the exogenous model)

Question 3

Endogenous growth models

Answer 3

*We remove the assumption of decreasing Marginal Product of Capital (MBK) and instead assume constant MBK.
*Although each category of capital on its own has decreasing MP, together they have constant MP (Key point: Due to externalities and spill-overs).
*Human capital’s importance due to enabling a higher steady-state level of output and capital.
*Output = A X ((D+K)^b) X (K^a) X (L^c)
D = Human capital
K = Physical Capital
Note (D+K)^b is expressing there is spillover between human and physical capital
*Private return does not equal social return
*Increasing MP produces divergence
*An endogenous growth theory implication is that policies that embrace openness,
competition, change and innovation will promote growth.

Question 4

Endogenous growth - Conditional convergence - What determines the steady state?

Answer 4

*Level of investment and savings
*Accumulation of human capital
*Institutions:
-Property Rights
-Regulatory institutions
-Macroeconomic Stabilisation
-Social Insurance
-Conflict management
-Political rights

Question 5

World bank Worldwide Governance Indicators

Answer 5

*Voice and accountability
*Political Stability and lack of violence
*Government effectiveness
*Regulation quality
*Rule of law
*Corruption

Question 6

Neutral VS Biased technology shift in production possibility frontier

Answer 6

Question 7

3 forms of economic efficiency

Answer 7

*Productive efficiency: The economy could not produce any more of one food without sacrificing production of another good, production possibility frontier.
*Allocative efficiency: Every good or service is produced up to the point where the last unity provides a marginal benefit to consumers equal to the marginal cost of producing
*Dynamic efficiency: Not just static efficiency, but over time as well (particularly important for R&D, innovation)

Question 8

Economic efficiency definition (Surplus)

Answer 8

Total surplus = Consumer surplus + Producer surplus

Question 9

Pareton criterion

Answer 9

Not possible to make one person better off without making another worse off.

Question 10

Compensation principle

Answer 10

Choose policies that yield the highest total economic surplus (Winners could compensate the losers and still be better off)

Question 11

Sources of Market failure

Answer 11

• Monopoly power
  
  • Asymmetric information
  • Externalities
  • Public goods - Often lead to free-rider
    *Non-rival: A good for which the marginal cost of its provision to an additional consumer is zero
    *Non-excludable: You cant exclude someone from consuming, so cant charge for its use.

Question 12

Replacement Effect (Monopolists view of innovation)

Answer 12

*Monopoly provides less incentive to innovate than a competitive industry.
*This is because new market entrants see the entire profit increase of entering the market, whilst monopoly’s new profit is destrys old profits.
*(Arrow, 1962)

Question 13

Cournout competition

Answer 13

*A fixed number of firms in the market
*All firms produce a homogeneous good
*Firms compete in terms of the quantities that they produce
*Firms do not cooperate

Question 14

Nash equilibrium

Answer 14

The Nash Equilibrium is a component of game theory. It states that no player’s outcome can be determined by changing strategy. It was devised by 1994 Nobel Prize for Economics winner John Nash.

Question 15

Efficiency Effect (Monopolists view of innovation)

Answer 15

*As with ‘Replacement effect’, however introduces the risk of a new market entrant entering as a low-cost firm in a duopoly.
*Now the cost of not innovating is losing the monopoly and its business.
*(Gilbert and Newbury, 1982)

Question 16

Innovation vs Competition

Answer 16

*Neck-and-neck firms have the same technology
*Lead-and-follower firms have different technologies
*Low competition - limited motivation for neck-and-neck innovation as they are already recieving moderate profits.
*As competition increases, firms raise innovation to “escape competition”.
*In high competition, firms have conducted significant innovation, leading to more lead-follower industries, so there is less motivation to innovate (Schumpetarian efffect).

Question 17

Optimal patent length

Answer 17

During the life of the patent, innovators earn profit area A
Patent expires in T years, firms will choose x(T) research intensity
*Present value for A for T years is V(x, T)
*Cost of research activity is r(x)
*So net gain to firm is V(x, T) - r(x), we want to maximise this gain - x(T)
When the patent expires, consumers gain surplus A, plus B (Formerly static deadweight loss)
*The present value of A+B in T years is CS(x, T)
*Optimal patent length maximises:
V[x(T), T] - r[x(T)] + CS[x*(T)]
*The optimal patent length is positive but finite
*Optimal patent length is shorter the more elastic demand is, or the lower the cost of R&D

Question 18

Optimal patent breadth

Answer 18

*Patents must be broad enough to prevent firms inventing around other patents.
*Patent lenght and breadth depends on market conditions: The more competitive, the longer, narrower patents should be (Denicolo, 1996)

Question 19

Efficiency: Pareto, Productive, Allocative, Dynamic

Answer 19

Question 20

Cumulative innovations

Answer 20

Cumulative innovation:
* A single innovation leads to several 2nd generation innovations (Or applications of the original innovation)
* A 2nd generation product requires many existing products
○ Anti commons problem: Everyone will want a piece of the innovators profits.
○ Double marginalisation. (Each firm in chain adds their margins.
○ Solution is vertical integration/consolidation.
And patent pools: Compile related patents into a pool to perform joint licensing as a one stop shop.

Question 21

Sequential innovations

Answer 21

Sequential innovation:
Different innovators sequentially developing on the previous innovation.
This leads to the ‘Hold up problem’:
* Due to the sunk cost nature of R&D investment, once you have invested you are exposed to the other parties opportunistic behaviours. So B doesn’t invest, and A will only invest if v1>c1
Because of the hold-up problem, a broad patent covering later developments of an innovation is not more efficient than a sequence of narrow patents.

Question 22

Cournot licensing

Answer 22

Pro:
* Increases the use of knowledge (benefit for both innovators & consumers)
* If a firm licenses its lower cost technology to a high cost firm, so long as fee<P-C, everyone is happy!

Con:
* Encourages the creation of alliances between firms that affect production & pricing decisions (anti-competitive practice; higher prices; loss for consumers)
*Will not happen if competition is Bertrand

Question 23

Types of Diffusion

Answer 23

Technology Diffusion
- Adoption of a good by new users in new places
Knowledge diffusion
-Where ideas spread from one agent to another

Question 24

Absorptive capacity

Answer 24

You need to already be at the forefront to actually understand external knowledge.

Question 25

Spillover summary

Answer 25

Question 26

Drivers of diffusion.

Answer 26