Nobel Prize for Economics 2018 – The economic importance of technological innovation and the environment

With the announcement of the winners of this year’s Nobel Prize for Economics, the annual and ever-anticipated process of Nobel Price announcements has come to an end. The prize for economics is the only one awarded for a social science instead of a natural science. Its discipline deals with processes in which many factors play a role that cannot always be assessed individually. Thus, a given theory –even one awarded a Nobel Prize – may turn out to be completely wrong if the conditions or assumption for it were to change. Thus economists argue over and over again over the quality and correctness of their models. And a solid empirical verification of economic models is usually not possible.

One can argue that for this reason the Nobel Prize for Economics is not really a Nobel Prize, for such an honor for the field of economics does not appear in the will of Swedish industrialist Alfred Nobel. The prize was first donated in 1968 in memory of Nobel by the Swedish Riks bank on the occasion of its 300th anniversary. Its correct name is “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel”. And indeed, it happens that such a Nobel Prize is awarded for an economic theory that explicitly contradicts another theory that in the past has already been endowed with a prize. For example, the early Nobel prizes often went to economists for developing the theory of rational utility maximization at the level of economic agents. In recent years, on the other hand, there have been more and more winners who strongly oppose this assumption and thus developed a field that today is called “behavioral economics”. The focus here lies on the many cognitive biases and irrationalities that we humans display when making economic decisions. Imagine this for the field of physics: Some awarded scientists follow classical mechanics, others quantum mechanics. That is simply unimaginable.

This year, too, a prizewinner is being awarded who stands in fierce opposition to a model for which a Nobel Prize has already been awarded before. Paul M. Romer will receive the Nobel Prize 2018 for his work on technological innovation and its importance for economic growth. This question about the most significant drivers of economic growthis indeed very important.Thus, already in 1987, the American economist Robert Solow received the Nobel Prize for his theory of economic growth on the basis of technological progress,which he developed in the 1950s. However, unlike Romer, Solow believed that the driving force of economic growth, i.e. technological progress, operates outside the economy and its agents, i.e. its companies and the public sector. Concretely, he saw technological progress as acting externally on the economy and developing independent of it (economists speak of exogenous factors). By contrast, the endogenous growth model attributed to Romer claims that economic growth is the result of endogenous factors, i.e. factors that are within the influence of firms and other entities within the economy. Romer also sees the technological progress as the driver of economic growth, but recognizes that this progress is dependent on the activities of market participants themselves. For example, he stresses the need for strong public and private sector institutions to explicitly promote innovation and incentivize individuals and businesses to innovate. Government policy thus has a major impact on the economic growth of a country by promoting innovation and competition. Especially in the areas of infrastructure and through investments in education, health, and telecommunications resultsignificant economies of scale, so Romer. And equally investments of companies in research and development are a key driver of technological progress and thus economic growth, as well as investment in people (“human capital”), e.g. through education and training. Romer’s findings generally enable us to better understand which market conditions favor the emergence of ideas for new profitable technologies: In general, an economy grows well when its policy makers and business leaders promote openness, competition, change, and innovation.

In this theory lies a clear political message to autocratic governments: the economy grows best in open societies! It may be surprising that a Nobel Prize can be earned for this rather intuitive insight. But in 1994 the Nobel Prize for Economics was awarded for the statement “What goes around comes around”.Behind both, however, lies a much more complex argumentation, or in the case of game theory very abstract mathematics, than the simplicity of the statement would suggest. And who says that simple, intuitive insights in economics can always be easily understood and modeled?

The second Nobel Prize this year also goes to an American. And it equally comes with a clear political message which should give Donald Trump in particular a good reason to reflect. William D. Nordhaus has dealt extensively with the economics of climate change, demonstrating how economic activity interacts with chemical and physical processes to evoke climate change. He succeeded in, as the Nobel Committee states, “integrating climate change into long-term macroeconomic analysis”. In particular, his DICE and RICE models (Dynamic Integrated Climate-Economy model and Regional Integrated Climate-Economy model) constitute highly aggregated models integrating economy, carbon cycle, climatic conditions and their effects by using theory and empirical results from physics, chemistry and economics. This type of environmental cost analysis allows among others for balancing the costs and benefits of explicit political or regularity measures targeting at slowing down the greenhouse effect,such as the introduction of a CO2 tax. The results of his work made Romer a vociferous advocate of long-term sustainable growth in the global economy and the introduction of government measures against climate change, which prompted him on the occasion of his announcement as a Nobel Prize winner to profoundly criticize the US government for its irresponsible climate policy.

The Nobel Committee writes about its reasoning for its choice of this year’s laureates of the Nobel Prize in Economics:

The study of how humanity copes with limited resources is at the heart of economics and, since its inception as a science, economics has recognised that the most important constraints on resources reflect nature and knowledge. Nature dictates the conditions in which we live and knowledge defines our ability to manage these conditions. However, despite their central role, economists have generally not studied how nature and knowledge are affected by markets and economic behaviour. This year’s laureates, Paul M. Romer and William D. Nordhaus, have broadened the scope of economic analysis by designing the tools that are necessary to examine how the market economy has a long-term influence on nature and knowledge.

It is about time, we can only conclude.