Decomposing the economy, Page 145-147:
There are many different ways of describing the economy. One is to follow the traditional textbooks in macroeconomics and deconstruct the economy into factors of production, such as physical capital, human capital, and labor. Another way is to follow the natural science textbooks and decompose the economy in the same way we decompose everything else: in terms of energy, matter and information. As we will see in this chapter, these two ways of parsing the world are not incompatible. In fact, knowing how to combine these approaches can be enlightning, since they can help us interpret traditional economic factors in term of physical quantities and social processes. Also, by connecting economic factors with their physical interpretation we will realize that there is one extra factor that we need to consider. The extra factor is knowhow and knowledge accumulated at the collective level, which gives rise to the diversity and sophistication of economic activities that I call economic complexity.
Describing nature in terms of factors of production, such as capital and labor, has a long tradition in economics. Adam Smith decomposed the economy into land, labor, and machinery—the last being a mixture of what modern economists refer to as physical capital and technology. Smith equated machinery, or fixed capital with an increase in people's ability to produce work, and hence saw the accumulation of physical capital as a determinant of economic growth. "The intention of fixed capital is to increase the productive powers of labor, or to enable the same number of labourers to perform a much greater quantity of work", he wrote. Smith saw the improvements in mechanics, such as those embodied in the steam engine created by his contemporary James Watt, as improvements in the ability of people to produce work: "Improvements in mechanics...enable the same number of workmen to perform an equal quantity of work with cheaper and simpler machinery".
During the twentieth century Smith's ideas were mathematized by economists, who used calculus and differential equations to create models of economic growth that hinged on the accumulation of different forms of capital. The earliest models equated economic output to the ratio between an economy's capital and labor when the economy was in equilibrium. Theuy also modeled economic growth as the tug-of-war between an economy's savings rate (the capital that it keeps for later use) and capital depreciation (the wear and tear that erodes capital).
Robert Solow advanced the prototypic model of economic growth in the 1950s—a timely develpoment, as the data needed to evaluate such models were just becoming available. Simon Kuznets, the Russian-born economist who fathered GDP, had finished the system of national accounts a couple of decades earlier, helping generate the economic metric that dominated the twentieth century. Solow's model, however, did not measure up well when it was compared with empirical data. As Kuznets famously remarked in his Nobel Prize acceptance speech, "The earlier theory that underlies these measures defined the productive factors in a relatively narrow way, and left the rise in productivity as an unexplained gap, as a measure of our ignorance".
Kuznets "measure of ignorance" is what we know technically as total factor productivity (TFP). TFP is how economists refer to the gaps between the economic output predicted by a model and the one observed in empirical data. (This gap is interpreted as the amount of output that an economy can produce with a goven endowment of inputs). This gap motivated economists to build on Solow's work, and during the second half of the twentieth century economists advanced a plethora of new economic growth models that improved the model of solow. The new models included new factors and new mathematical tools to address the process of factor production and accumulation.
Yet not all economists agreed that the use of aggregation was the best or only path to explain economic growth and development. Wassily Leontief—Solow's PhD advisor and also a Nobel Proze Winner—argued that the main problem lay in the reliance on aggregates that disregarded information about specific industries. In his 1971 address to the American Economic Association Leontief wrote, "The time is past when the best could be done with the large sets of variables was to reduce their numbers by averaging them out or what is essentially the same, combining them into brand aggregates; now we can manipulate complicated analytical systems without suppressing the identity of their elements." Michael Porter, an influential economist working on competitiveness at Harvard Business School, also har concerns about the overreliance on aggregation. Instead, he advocated the use of "specialized factors". When discussing the competitiveness of nations on his book On Competition, Porter remarked:
According to standard economic theory, factors of production—labor, land, natural resources, capital, infrastructure—will determine the flow of trade. A nation will export those goods that make most use of the factors which is relatively well endowed. This doctrine, whose origins date back to Adam Smith and David Ricardo and that is embedded in classical economics, is at best incomplete and at worst incorrect... Contrary to conventional wisdom, simply having a general work force that is high school or even college educated represents no competitive advantage in modern international competition. To support competitive advantage a factor must be highly specialized to an industry's particular needs—a scientific institute specialized in optics, a pool of venture capital to fund software companies... Competitive advantage results from the presence of world-class institutions that first create specialized factors and then continually work to upgrade them.
Decomposing the economy, Page 145-147:
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