Innovation, growth and marginal cost

Mainstream economic wisdom says innovation is one of the things that will return the world economy to growth.  Therefore governments should adopt policies to encourage knowledge development and innovation.

As I meditate on this I think that in a previous reincarnation I must have been a charter member of the skeptics society.

Lets consider the effect of innovation on marginal cost.  Price is determined by supply and demand and  is set at the marginal cost of producing an item.   Marginal cost is the cost of the last item produced and will be the price at which any item will be sold.  If price is above marginal cost, then another producer will enter the business and more items will be produced.  If the price is below marginal cost, some producers will leave the business until the price rises.

The traditional view is that innovation reduces marginal cost and encourages growth.  For the most part this has probably been true.  What’s the point of innovation that doesn’t reduce costs?  Keep in mind that to contribute to growth new products have to be useful and people have to buy them.

However, there is no law that says innovation has to reduce costs and it may be that we are now using innovations that are more expensive.  I’m thinking of oil, gas and mineral extractions where new and expensive techniques have made possible the recovery of difficult deposits.

In these cases the marginal cost is rising and the innovations are used only when the price rises enough to pay for the innovation.  Rather than encouraging growth these innovations are slowing the rate of negative growth.

Another complication in all this is that spending more money on energy is reducing the resources for other items.  This means a whole raft of adjustments throughout the economy.

Innovation has been important to our standard of living and no doubt innovators will make further changes to our quality of life.  It is not clear that innovation will return us to economic growth and save us from an economic crisis.

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