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THE CO-EVOLUTION OF INNOVATION, DEMAND AND GROWTH*
January 2013
Pier Paolo Saviotti, INRA-GAEL, Université Pierre Mendès-France, BP 47, 38040 Grenoble, France E-mail: [email protected]
Andreas Pyka University of Hohenheim, Economics Institute, Wollgrasweg 23, D-70599
Stuttgart, Germany, E-Mail: [email protected]
Abstract In order to explain long-run economic development we analyse in this paper the interplay
between supply-side and demand-side processes. On the supply-side three different
innovation processes are observed and interact: (i) growing productive efficiency, (ii) the
emergence of new sectors and (iii) the increasing quality and differentiation of existing
products. On the demand-side we analyse the meaning of disposable income and varying
preference systems. The analysis is undertaken with the help of a numerical model of
economic growth by the emergence of new industries. Our results show that the time path
of economic development which we observe could not have been generated by taking into
account a supply-side based view on innovations alone. Without making reference to the
formation of an adequate demand, development processes cannot be explained. The three
processes need to be combined because each one individually would not suffice to generate
long run economic development. However, only with the formation of an adequate demand
long run economic development becomes sustainable.
1) INTRODUCTION
Innovation is increasingly recognized as one of the most important factors which contributed
to economic development, at least since the time of the industrial revolution. Although a
very large number of papers studied the relationship between innovation and economic
development, almost all of them focused exclusively on the supply side. Yet it seems obvious
* The research leading to these results has received funding from the European Union Seventh Framework
Programme FP7/2007-2013 under grant agreement n° SSH-CT-2010-266959; project PICK-ME.
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that if there had been no demand for the innovations created since the beginning of the
industrial revolution, such innovations could not have contributed to economic
development. Rosenberg and Mowery (1978) stated „ … rather than viewing either the
existence of a market demand or the existence of a technological opportunity as each
representing a sufficient condition for innovation to occur, one should consider them each as
necessary, but not sufficient, for innovation to result; both must exist simultaneously.“ While
the completely static nature of demand theory - which students still learn in economics
textbooks – together with the absolute indifference to the nature of the goods and services
which in different periods are the objects of consumer choice, represented considerable
obstacles to the analysis of long range patterns of economic development, these faults are
no excuse for the absence of an adequate demand theory, especially within evolutionary
economics. To be fair, some pioneering papers started analyzing the problem of demand.
Reference to some of these will be made in the following sections. However, and in spite of
the value of these pioneering efforts, the construction of a demand theory adequate to
explain the dynamics of an economic system, the growth of which is driven by innovation
and structural change is at its very beginning. In this paper we focus on a number of
problems which are at the heart of such emerging demand theory, especially of a theory
focusing on long range economic development. We are going to analyze the problem at
three different levels:
(i) no innovation could have had an impact on economic growth if nobody had purchased it.
This means that consumers and or users needed to have (a) a high enough income to
purchase the innovation and (b) a preference system compatible with the purchase of the
given innovation;
(ii) the relative dynamics of demand and of process efficiency have an important impact on
the process of economic development. Saturation of demand and of markets can play a
powerful role in affecting the dynamics of the economic system;
(iii) finally, the role of demand is not separable from that of supply. In an innovative
economy search activities affect demand, which in turn affects future search activities and
thus demand in the following periods. This situation can be adequately described as the co-
evolution of demand, innovation and supply.
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Each of these points will now be analyzed separately. We carry out the analysis by means of
our TEVECON model of economic development by the creation of new sectors (Saviotti and
Pyka 2004a, 2004b).
2) HISTORICAL PATTERNS AND CONCEPTUAL BACKGROUND
Evolutionary economics owed its origin to the difficulties encountered when attempting to
use neoclassical economic theory to explain the nature and impact of innovation on
economic development. Given this beginning it is not surprising that until the present most
of the work in evolutionary economics focused on the supply side. On the one hand, this lack
of attention for demand is shared with recent developments in endogenous growth theory
(see for example Romer 1990; Aghion and Howitt 1992; Grossman and Helpman 2001). On
the other hand, models which focus on demand tend to stress structural change and to
belong to a neo-Keynesian approach (Kaldor 1957; Pasinetti 1981; Aoki and Yoshikawa 2002)
without considering long term effects of innovation.
2.1) LITERATURE REVIEW: EVOLUTIONARY DEMAND THEORY
Recently a growing attention has been paid to demand in models of economic growth, both
orthodox (Murphy, Shleifer and Vishny, 1989; Matsuyama ,2002; Foellmi and Zweimuller,
2006) and evolutionary (Bianchi, 1998; Andersen, 2001, 2007; Aversi et al ,1999; Metcalfe,
2001; Saviotti, 2001; Witt, 2001, Ciarli et al 2010). A very recent paper by Nelson and Consoli
(2010) makes the brave attempt to sketch a broad outline of such a demand theory. They
start from the need to reject the neoclassical assumption of perfect and complete
knowledge and, following Simon and March (Simon 1954, 1955; March and Simon 1958),
propose to replace it with a form of bounded rationality similar to the one used to explain
the behaviour of firms. Consumers would then not optimize but construct consumption
routines which guide their choices. In this approach the mechanism whereby routines are
constructed are of crucial importance. In demand as in supply innovation creates
uncertainty. Thus, consumers' knowledge is not just likely to be imperfect but to become
more so when new types of goods and services completely unknown to them are introduced
into the economic system. Especially at the beginning of the life cycle of the emerging goods
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and services very few consumers are likely to be able to overcome this uncertainty. In fact, in
these circumstances also consumers can be expected to act as innovators but to require a
threshold level of human capital to do so (Saviotti 2001). Furthermore, the role of lead
consumers (Malerba et al. 2007), patterns of imitation and differentiation (Saviotti 2001),
routines, user-friendly technologies can be expected to help overcoming the uncertainty
inherent in the emergence of new goods and services. Imitation patterns of lead consumers
can reduce such uncertainty but they are unlikely to lead to a complete homogeneity of a
consumer population. In fact, some consumers wish to imitate those who are better off than
themselves but other will want to distance themselves from most of the others, thus giving
rise to a segmentation of a consumer population (Granovetter and Soong 1986). Another
very important mechanism by means of which consumers can overcome the knowledge
barrier that they face to use new products and services consists of the development of user-
friendly technologies. Such technologies are designed to drastically reduce the amount of
knowledge required on the consumers’ side. For example, the development by Apple,
subsequently imitated by Microsoft, of the visual representation of operations which
secretaries and typists had been using for a very long time and which were very familiar to
them, drastically reduced the knowledge barrier which the average consumer needed to
overcome to be able to use computers to do text processing. This is just one of many
possible examples. The general underlying principle is that if all consumers needed to
understand well how cars, televisions, portable telephones, photographic cameras etc.
function, the markets for all these products would be much smaller than the ones we can
observe. Such general principle can be expressed by means of the twin characteristics
representation of product technology (Saviotti and Metcalfe 1984) by saying that
technologies become user friendly when their use requires only or predominantly
knowledge of the service characteristics of a given technology and not of its internal
structure.
2.2) THE ROLE OF PREFERENCES AND WANTS
All the previous considerations imply that the construction of consumption routines occurs
by means of social interactions, be they within imitation or learning patterns or through the
intermediation of firms in the construction of user-friendly technologies. While this seems
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quite a logical and realistic observation, it could have problematic implications for a theory
of consumer preferences. Routines are not identical to preferences but we cannot expect
the former to be incompatible with the latter. Thus, the social interaction component of
routines, which is likely to be translated into a social interaction component of preferences,
which contradicts the neoclassical assumption that utility functions are based solely on the
resources of each individual. That utility functions could be affected by social interactions
had been noted long time ago by Georgescu-Roegen (1965, 1970, 1976) and by Hirsch
(1976). According to the former the choice function of a peasant in a village depends on
both the quantity of goods/services owned by the individual and by the village institutions.
However, it is not obvious that this non-independence assumption applies only to peasant
villages and that it becomes irrelevant for modern industrialized societies. According to
Hirsch (1976) with increasing affluence people do not feel better off unless they are
relatively better off.
According to the theory of demand presently studied in textbooks preferences can be
considered fixed and the only problem that should concern economists is the allocation of
resources under constraints. However, this assumption is at best valid as a short term
approximation. If our objective is to analyze long range patterns of economic development
the formation of preferences becomes a meaningful task. A fundamental question one
needs to raise here is whether consumers can have preferences for objects of consumption
of which they have never known the existence or the properties. Here we tend to think that
consumers can at best have very fuzzy preferences for these objects of consumption and
that such preferences can at best be related to the similarity of the service characteristics of
the new and of the pre-existing goods and services. Thus, the innovations which create
important knowledge discontinuities for producers are likely to significantly affect
uncertainty for consumers as well. However, an important asymmetry between consumers
and producers is the possibility already mentioned to create user-friendly technologies
which reduce the knowledge barrier the former need to use the new goods and services. In
spite of this possibility, consumers are increasingly required to act as innovators (Bianchi,
1998) by learning types of knowledge relevant for the use of new goods and services.
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Another concept that following Witt (2001) and Nelson and Consoli (2010) is regarded as
extremely important in the construction of an evolutionary theory of demand is that of
wants. Ulrich Witt is concerned among other aspects with the possible satiation of demand
and with the impact it could have on growth. In studying the potential impact of satiation on
growth Witt is following the suggestion by Pasinetti (1981) that demand can saturate and
thus induce a bottleneck in economic development, a suggestion to which we will return in
the next section. According to Witt, some wants correspond to basic physical needs, such as
the need for food, sleep etc. While these needs can quantitatively be saturated, they can be
satisfied in a wide and growing variety of forms. The increasing variety of foods available
today to the average consumer today is a case in point. However, this increasing internal
differentiation is not enough to explain the absence of satiation. Together with it, Witt
considers two other mechanisms which might have the same effect. First, the satisfaction of
these basic wants can be coupled with other services which are complementary to them,
such as the atmosphere in a restaurant created by decoration or music. Second, the
satisfaction of these basic wants can be coupled with physical tools, such as a fancy bed for
the want to sleep.
2.3) DEMAND SATURATION AND PRODUCT AND QUALITY DIFFERENTIATION
Demand saturation had been assumed by Pasinetti (1981) in his treatment of the
relationship between structural change and economic growth. Generalizing from Engel's law,
Pasinetti assumes that demand saturates in all sectors, thus leading to an imbalance
between demand and continuously growing productive efficiency. In turn this imbalance
leads to a bottleneck consisting of the possibility to supply all demanded output by a falling
percentage of the labour force and the other required resources. The bottleneck could be
overcome by means of the emergence of new sectors which allow for the compensation of
the falling ability of incumbent sectors to create employment. The earliest version of our
model (Saviotti and Pyka 2004b) shows that in presence of complete demand saturation the
emergence of new sectors would allow an economic system to overcome Pasinetti's trap. In
our subsequent work we study the possibility that demand saturation is not complete and
that emerging sectors do not produce homogeneous and unchanging outputs during their
life cycle. Recent empirical work by Chai and Moneta (2010) and modelling work by Saviotti
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and Pyka (2009) shows that complete saturation as a function of income rarely occurs. For
most goods and services, Engel's curves have rather irregular shapes, the most general but
not invariable feature of which can be a slowdown in the rate of growth of demand with
income as the sector matures. In our modelling work we show that complete demand
saturation occurs only when no new sectors emerge and when the demand curves of
different sectors are independent. These findings do not entirely invalidate Pasinetti's idea
that an imbalance would arise between continuously growing productive efficiency and
saturating demand. Such an imbalance would still occur provided that the rate of growth of
demand was lower than the rate of growth of productive efficiency during the mature phase
of industrial sectors. Furthermore, even if the bottleneck in economic development that
Pasinetti was referring to as a consequence of the above imbalance were not to occur,
increasing variety, increasing sectoral output quality and internal differentiation would still
provide mechanisms which would enhance the potential of economic development.
An important trend in economic development occurring during the XXth century was the
growing quality and differentiation of goods and services. This trend is superimposed upon
the emergence of new sectors in such a way that product quality and differentiation grow
after the establishment of the new sector. In this process goods and services ceased to be
homogeneous. Many different attempts occurred to incorporate this heterogeneity in
demand theory (e.g. Wadman 2000). Finally, Ironmonger (1972) and Lancaster (1966, 1971)
assumed that consumers are not interested in products for their own sake but for their
characteristics. In our modelling work we use a version of Lancaster's theory (Saviotti and
Metcalfe 1984) in which a product is represented by two sets of characteristics describing
the internal structure of the technology and the services supplied to users and consumers
respectively. The two sets are called technical and service characteristics. Thus, we measure
product quality as an aggregator of service characteristics and product differentiation as the
range of services supplied. Clearly, the possibility of increasing product quality and
differentiation would not be conceivable without such a growingly heterogeneous nature of
products. Another departure we made from Pasinetti's work consists of taking into account
not only the emergence of new sectors but also the considerable increase in output quality
and differentiation internal to each sector.
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2.4) DEMAND DEVELOPMENT AND DISPOSABLE INCOME
The trend towards growing product quality and differentiation is historically recent.
Although we can find its origin during the industrial revolution, until the end of the XIXth
century most people spent almost all their income in what could be called necessities (e.g.
food, clothing, and housing). In this situation they could not be expected to purchase any
other (non-necessity) goods or services, given that by definition necessities cannot be
substituted by anything else. The possibility to purchase ‘higher’ goods and services required
the formation of what we call disposable income, an outcome which was necessarily
dependent on the growing efficiency of the processes producing necessities. This growing
efficiency started to create the required disposable income only at the beginning of the XXth
century, and even then only for the richest countries in the world (Hobsbawm 1968).
Important as it was, growing productive efficiency alone could not explain the phenomena
we observed during the XXth century. However efficient you make the production of bricks
and shoes, you cannot by that create cars or computers. Creativity, the capacity to give rise
to completely new objects of consumption is required in addition. The question then arises
of how creativity could be unleashed at a given time, let us say towards the end of the XIXth
century. A factor which contributed to the emergence of creativity is constituted by the
great progress made by science and technology during the XIXth century, progress which
allowed mankind to modify purposefully its external environment in an unprecedented way.
However, science and technology can give us the knowledge required to create new goods
and services but two conditions need to be satisfied for that to happen: (i) science,
technology and innovation require resources and (ii) consumers need to have a disposable
income to purchase the new goods and services.
The disposable income required for most consumers to be able to purchase goods and
services higher than necessities only became available at the end of the XIX century. This
happened by the combination of (i) the growing productive efficiency of all pre-existing
sectors, which reduced the cost of their output and the increasing income which would be
created by the new sectors, due to the relative investment and wages. All of these processes
required innovations creating the new goods and services in quantities, qualities and at
prices which could create a large enough demand for them to be produced.
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2.5) THE CO-EVOLUTION OF INNOVATION AND DEMAND
The dynamics of such a combination of supply- and demand-side processes cannot be
conceived as a set of independent events but as a co-evolutionary process of these different
and often complementary events. Co-evolution occurs when two variables influence each
other in such a way that as one of them grows or falls it induces a corresponding growth or
fall in the other one. In the economics of innovation attention has been focused on the co-
evolution of technologies and institutions (Nelson 1994), arguing that new technologies
require appropriate institutions and that the creation of such institutions can speed up the
development of new technologies and enhance their scope. The concept of techno-
economic paradigm (Perez 1983, 2007) describes with a different name the same process. In
our case the co-evolution occurs by the creation of an innovation, investment, creation of
employment and of income. Higher incomes can then induce the creation of higher quality
and of more differentiated products until the market corresponding to the new sector
eventually saturates inducing the emergence of newer sectors.
Here we propose a mechanism whereby different processes co-evolve giving rise to the
economic development patterns which we observe. The following stylized facts summarize
the previous discussion:
New sectors producing new goods and services are created by important innovations;
new markets emerge corresponding to these new sectors;
the internal quality and differentiation of these new sectors increases during their life
cycles and
the education levels of the population rise very rapidly and simultaneously with the
above processes.
A pattern of interactions which could explain the observed events is as follows:
(i) Observing the important advances made by science and technology firms start
investing in industrial R&D, which becomes institutionalized (Freeman and
Soete 1997);
(ii) this gives rise to innovations which open up new markets;
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(iii) This also creates a growing demand for education at all levels;
(iv) as a consequence of (iii) the higher competencies required to produce the new
and higher quality goods and services become available and
(v) as a further consequence of (iii), the higher wages which are paid in exchange
for higher competencies contribute to create (a) the purchasing power required
to buy new as well as higher quality goods and services and (b) to fund the
demand for higher education.
In this paper we will not undertake the exploration of the full co-evolutionary pattern
outlined above. Here we will pursue a more limited exploration of the co-evolution of
demand, of productive efficiency, of the emergence of new sectors and of the increasing
quality and differentiation in these sectors.
As a consequence of the previous considerations we consider the growing efficiency of
productive processes, the increasing variety due to the emergence of new sectors and the
increasing quality and internal differentiation of incumbent sectors as conditions which are
jointly required to create the pattern of economic development which we observe.
In our paper we explore this situation by means of a demand function which includes the
contributions of price, product quality, product differentiation, and an income term. The
process of economic growth affects the income related term in ways which depend on a
number of parameters of the TEVECON model, thus affecting the rates of economic growth
in the following periods.
Assuming that consumers have a high enough income to purchase a new good or service
they must also value it positively. In other words, they must have positive preferences for it.
In this paper we will analyze this problem by inserting a preference related term into the
demand function. In absence of a theory of preference formation we will approach the
problem in the following ways: we will assume that consumers’ preferences are
systematically biased towards (a1) newer goods and services or towards (a2) older goods
and services. These ‘switching preference’ experiments will allow us to investigate the
extent to which preferences support or hinder the evolution of particular types of demand
even when an adequate income share is available.
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3) A MODEL OF ECONOMIC DEVELOPMENT BY THE CREATION OF NEW SECTORS
Our model of development has been developed over the past years and has already
undergone a number of modifications and extensions (see Saviotti and Pyka, 2004a, 2004b,
2008a, 2008b). We will give first a brief description of the model and then introduce the
equations most central for this study. For a description of the formal structure we refer to
the respective references. In Pyka and Saviotti (2010) a detailed description of the basic
mechanisms, the parameters applied, the model’s robustness as well as major outcomes are
summarized.
In the model each sector is generated by an important innovation. Such innovation creates a
potential market and gives rise to what we call an adjustment gap. The term adjustment gap
is due to the fact that as soon as a potential market it is created it is in fact empty: neither
the productive capacity nor the demand for the innovation is present. They are gradually
constructed during the life cycle of the new sector. As the new sector matures the
adjustment gap tends to fall: a productive capacity which in the end matches demand is
created. When this happens the sector enters its saturation phase. The productive capacity
is generated by Schumpeterian entrepreneurs establishing new firms initially induced by the
expectation of a temporary monopoly and of the related supra normal profits. The success
of the innovation gives rise to a band wagon of imitators. The number of firms in the new
sector gradually rises, but this also raises the intensity of competition in the sector, thus
gradually reducing the inducement to further entry. After the intensity of competition in the
new sector reaches levels comparable to those of established sectors the new sector is no
longer innovating but becomes part of the circular flow. When a sector achieves maturity in
the way described above an inducement exists for Schumpeterian entrepreneurs to set up a
new niche, which can eventually give rise to the emergence of a new industry. In other
words, the declining economic potential of maturing sectors induces the creation of newer
and more promising ones.
Competition plays a very important role in this process of creation of new industries.
Entrepreneurs are induced to establish new firms by the expectation of a temporary
monopoly, that is, by the absence of competition. However, the new sector would not
achieve its economic potential unless imitative entry took place. In this way the intensity of
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competition rises, thus reducing the inducement to further entry. An additional contribution
is made to the dynamics of our artificial economic system by inter-sector competition. Inter-
sector competition arises when two sectors produce comparable services. Inter-sector
competition is an important component of contestable markets (Baumol et al. 1982) and can
keep the overall intensity of competition of the economic system high even when each
sector achieves very high levels of industrial concentration.
In our model the variety of the economic system plays an essential role. Economic variety is
approximated by the number of different sectors. By raising variety the creation of new
sectors provides the mechanism whereby economic development can keep occurring in the
long run. In this way the economic system can escape the trap generated by the imbalance
between rising productivity and saturating demand (Pasinetti 1981, 1993; Saviotti 1996)
which would occur in a system at constant composition. This also affects the macroeconomic
employment situation: In particular, this artificial economic system can keep generating
employment even when employment creation is falling within each sector (Saviotti and Pyka
2004b).
In order to illustrate qualitatively the developments generated by our model figure 1a shows
the development of the number of firms in a certain industry. Within a wide range of
conditions the number of firms in each sector grows initially, reaches a maximum and then
falls to low values. Within these conditions each sector seems to follow a life cycle, similar to
the ones detected by Klepper (1996), Klepper and Simons (2005), Jovanovic and MacDonald
(1994), Utterback and Suarez (1993). However, in our model this industry life cycle is created
by variables very different from those used by the previous authors who refer to increasing
returns to R&D, radical innovations or the emergence of dominant designs. In our case the
cyclical behaviour is caused only by the combined dynamics of competition and of demand.
We do not wish to say that cyclical behaviour cannot arise under the conditions identified by
the previous authors. We simply say that cyclical behaviour can arise also from the interplay
of competition and of demand. Figure 1b displays the development of the intensity of
competition and one clearly sees the impact of intra-industry dynamics as well as the
additional effect of inter-sector-competition after the emergence of new sectors.
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#
t
ICi
t
fig. 1a) number of firms fig. 1b) intensity of competition
In the following paragraphs we describe briefly the formal aspects of our model. The main
equation governing the dynamics of each sector in the model is:
t
i
t
i
t
i
t
i
t
iMAICAGFAkdN
1 (1)
where dNit is the change in the number of firms in sector i at time t, AGi
t is the adjustment
gap at time t, ICit is the intensity of competition at time t, and MAi
t is the number of mergers
and acquisitions at time t. Equation (1) represents the rates of entry (FAit · AGi
t) and exit (ICit,
MAit) into and out of sector i. Thus, dNi
t is the net entry of firms in sector i at time t. In this
equation co-evolution is represented by the term FAit · AGi
t.
The exit term ICit includes inter- and intra-industry competition (for a detailed description
see Saviotti and Pyka 2008a). The second exit term MAit includes besides exits via mergers
and acquisitions also failure and bankruptcy (see Saviotti, Pyka, and Krafft 2007).
t
ii
tt
iDDAG max (2)
The adjustment gap AGit (displayed in figure 2c) is very large right after the creation of the
sector, and later it decreases gradually, although not at all times. It is in fact possible for the
adjustment gap to grow during certain periods if innovations following the one creating the
sector improve either the performance of the product or the efficiency with which it is
produced, or both. In our model search activities affect both the maximum possible demand
(Dtmax,i) and the instant demand (Dt
i) in a sector i. If we consider that analytically the
adjustment gap (equation 2) is defined as the difference between these two types of
demand, we can understand that the time path of the adjustment gap depends on those of
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Dtmax,i (fig. 2b) and of Dt
i (fig. 2a). During particular periods it is possible for Dtmax,i to grow
more rapidly than Dti, thus enlarging the adjustment gap, or delaying the saturation of the
market. In the long run we expect the adjustment gap to be reduced to zero or to a low
constant value, i.e. the market to become saturated.
1 101 201 301 401
demand of sector i
t1 101 201 301 401
maximum demand of sector i
t 1 101 201 301 401 t
adjustment gap of sector i
fig. 2a) Demand fig. 2b) Maximum demand fig. 2c) Adjustment gap
FAit represents financial availability, the amount of money present in the economic system
that financial institutions are prepared to allocate to sector i at time t. Thus, FAit depends on
money as well as on the presence of financial institutions capable of judging the prospects of
growth and development of sector i at time t. It is in principle possible for an economic
system to have enough money but to lack the financial institutions capable of assessing the
potential of a new sector (Pyka and Saviotti, 2009). The role of financial institutions has been
crucial in the process of economic development and financial innovations have been
required several times to adapt these institutions to changes in the economic environment
(Perez 1983, 2002, 2007). AGit , the adjustment gap, is the size of the potential market of
sector i at time t. Co-evolution of the technology of sector i and of FAit occurs when FAi
t
grows with AGit and AGi
t grows with FAit .
Starting from the behaviour of microeconomic variables we can also calculate the curves for
aggregate variables. Figure 3 shows the time path of aggregate employment, obtained by
aggregating the employment curves of individual sectors.
15
-
20
40
60
80
100
120
1 51 101 151 201 251 301 351 401 451 t
# aggregate employment and trend
fig. 3: Aggregate employment curve
As can be seen in figure 3, the aggregate employment curve, constituted by the
superposition of the individual sectors’ employment curves, can give rise to a constant or
growing employment even when the ability of each sector to create employment declines.
Using the number of sectors in the economic system as an approximate measure of variety it
can be seen that these results support the hypothesis that variety growth is a necessary,
although not sufficient, condition for the long term continuation of economic development
(Saviotti 1996). In the rest of the paper the slope of the quasi linear part of the aggregate
employment curve will be used as a measure of the performance of the economic system.
4) THE FORMATION OF DISPOSABLE INCOME
To explore how the emergence of innovations can give rise to the disposable income
required to purchase them we modify the demand function (4) which we had used in
previous versions of our TEVECON model to include an income related component:
i
iiiDispi
t
ip
YYDDD
,
0 (3)
Where Di0 is the initial demand for the output of the new sector i, Ddisp,i is the disposable
income which can be allocated to purchase the new good or service i, Yi and ΔYi are the level
of services supplied by the new product/service and the degree of product differentiation, pi
is the price of the new product/service. The disposable income Ddisp,i can be calculated by
subtracting from total income the expenditures on all previous goods or services. In the
TEVECON model such disposable income is created due to the combination of the growing
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productive efficiency of pre-existing sectors and of the increased output and employment
following the creation of a new sector based on an important innovation. The extent of the
increase in income thus generated depends on the size of the market for the new product or
service and on all the parameters affecting the demand equation (3).
In figures 4-6 we display the curves for the number of firms Nit, for income and for demand
obtained with the new demand function (4). These results correspond to what we call from
now on the standard scenario which is taken as the basis for our further explorations.
fig. 4: Development of the number of firms in the different industries
fig. 5: Income development
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fig. 6: Demand development in different sectors
The time path of the number of firms Nit (fig. 4) and of income (fig. 5) is qualitatively similar
to that obtained with the previous formulation of the demand equation (Saviotti and Pyka
2008). The number of firms rises first, reaches a maximum and then falls to a low value – in
other words the populations of firms describe a sequence of industry life cycles (ILCs). The
income generated (figure 5) keeps rising all the times. The emergence of each sector is
accompanied by an initial period of very fast increase in income followed by a period in
which income rises much more slowly. A similar tooth like shape is shown by consumption
and investment.
The demand curves for individual sectors obtained with demand function (3) displayed in
figure 6 differ from those which we had obtained in Saviotti and Pyka (2008) where the
disposable income was not considered. There, demand rose in the initial phases of a new
sector before reaching a level of saturation; also the sectorial demand curves where
independent of each other. With the new demand function (3) which includes explicitly
disposable income, sectorial demand curves interact. The interactions are of two types: the
emergence of a new sector raises income and as a consequence increases the demand for
older sectors giving rise to spikes in the demand curve since part of the higher income is
available also for the previous sectors; (ii) the fall in demand occurring in the mature phase
of a sector occurs because one way of purchasing new goods or services is to spend less on
pre-existing ones. On the whole we consider that our new demand function including an
income constraint is superior to the previous one because it represents not only what
consumers would like to purchase, as the previous one, but also what they can purchase.
4.1) PRODUCTIVE EFFICIENCY, OUTPUT VARIETY, PRODUCT QUALITY AND SECTOR
INTERNAL DIFFERENTIATION
18
Growing productive efficiency, increasing output variety, product quality and sector internal
differentiation contribute jointly to economic development. To understand their role we
would need to be able to separate them. In past work (Saviotti and Pyka 2004c) we
approximated output variety by the number of sectors and used the informational entropy
function to calculate it. It is more difficult to separate productive efficiency from product
quality at the sectoral level because they are jointly produced. For example, during a given
period the output of a sector changes both in quantity and in quality. To take a typical
example, the cars produced today differ not only in numbers but also in quality from those
which were produced in the 1950s. In TEVECON product quality is explicitly present in the
demand function as Yi, the level of services supplied by a product. Yi can be considered an
aggregator of several product service characteristics (Saviotti, Metcalfe, 1984). To explore
the effect of changing product quality on economic development we modified the
parameters of the equations of Yi and of Yi, which represent product quality and product
differentiation respectively. We created two extreme cases, one in which there is no change
in product quality and product differentiation and one in which these changes are high. We
will call these two scenarios low quality and high quality respectively.
Figures 7-12 show the impact of on a number of model variables. To abstract from some
particularities of the first sector, in the graphs the development of the respective figures in
the second industry are displayed. Figure 7 shows the time path of product quality and of
product differentiation in the two cases. As it could be expected, in the low quality case
product quality does not change while in the latter case it grows. Figure 7 also shows that in
the high quality scenario it takes longer for new industries to emerge. Figures 13 and 14
show the development of disposable incomes in the low and high quality scenarios. as
Figures 15 and 16 illustrate the aggregate income and employment developments for the
low and high quality scenarios.
19
fig. 7: Product quality (yit) in the low quality (dark) and high quality (light) case
fig. 8: Sectorial demand (Dit) in the low quality (dark) and high quality (light) case
fig. 9: Sectorial output (qit) in the low quality (dark) and high quality (light) case
fig. 10. Sectorial wages (wit) in the low quality (dark) and high quality (light) case
fig. 11: Quantity of human capital (HCit) used in a sector in the low quality (dark) and high
quality (light) case
20
fig. 12: Quality of human capital (hit) in the low quality (dark) and high quality (light) case
fig. 13: Disposable income created in the economic system for the low quality case
fig. 14: Disposable income created in the economic system for the high quality case
fig. 15: Difference between employment development in the low and high quality scenario
21
fig. 16: Difference between income development in the low and high quality scenario
The changes induced by the increase in product quality during the life cycle of a sector can
be summarized as follows:
The difference of the two scenarios is best displayed in figure 7 where the immediate effect
of the switch from the low to the high quality scenario can be seen in the sharp increase of
the output quality variable Yit, which overtakes in the high quality scenario and reaches a
significantly higher value. At a sectorial level this affects demand Dit which remains almost
constant in the low quality case while it grows considerably in the high quality case (figure
8). Output qit only moderately increases in the first periods in order to decrease again in the
low quality case while it grows in the high quality case over the observed time interval
(figure 9). Also sectorial wages wit finally remain constant on a lower level in the low quality
case compared to increasing sectorial wages the high quality case (figure 10). This difference
in the development of sectorial wages is also reflected in the quantity of human capital (HCit)
which rises and falls more rapidly and subsequently settles on a lower value in the low
quality case with respect to the high quality case (figure 11) and in the quality of human
capital (hit) which falls gently in the low quality case while it grows in the high quality case
(figure 12). Improving product quality necessitates higher quantities and qualities of human
capital accompanied by higher wages.
Figures 13 and 14 display the development of the disposable income (Ddispo,it) for the two
scenarios. The disposable incomes to purchase goods and services from new industries grow
faster in the low quality scenario supporting the faster emergence of new industries. In the
high quality scenario the increasing disposable incomes generated from the emergence of
new industries is partly used to purchase higher quality and differentiated goods and
22
services in the mature industry. From this follows a positive feedback on wages and human
capital. This leads to a pronounced difference on the aggregate level of the artificial
economy. Figure 15 displays the difference in the aggregate employment development in
the two scenarios. It immediately can be seen that the employment figures in the low quality
scenario always are superior to the employment figures in the high quality scenario.
However, this is not the case with respect to the aggregate income. The higher aggregate
incomes (figure 16) for the low quality scenario are to be observed only in the first periods.
The trend of higher growth rates in income changes around period 1000 and the income
differential becomes smaller. In period 1800 finally aggregate incomes in the high quality
scenario overtake despite the lower employment levels.
The picture that emerges from these experiments is that in the early stages of economic
development our artificial economic system would have had a higher rate of growth of
aggregate income and of aggregate employment if it had been developing by creating new
sectors based on new products and services, but if it had not improved the quality of these
new products and services after they had been created. However, this higher rate of
aggregate growth would have occurred with lower wages, lower sectoral demand and a
lower quality of human capital. Thus, a larger employment pool would have been created
but with a lower quality of human capital of the workforce and, consequently, with lower
wages and with a lower sectoral demand. In summary, the low quality scenario would have
entailed more jobs with lower competencies and lower wages than the high quality scenario.
The previous results are not independent of the time horizon chosen. Thus, the tradeoff
between the faster rate of aggregate growth and the lower level of individual welfare of the
low quality scenario and the lower rate of aggregate growth and the higher level of
individual welfare of the high quality scenario which exists for income in a relatively short
time horizon disappears in a relatively longer time horizon in which the high quality scenario
dominates both aggregate income growth and individual welfare. On the other hand
employment keeps growing faster in the low quality case whatever time horizon we take
into account.
To interpret correctly these results we have to bear in mind that in our TEVECON model a
new sector is created when the pre-existing ones are saturated. The distinction between the
23
low and the high quality scenarios implies that saturation can occur both in volume and in
value (Saviotti, Pyka, and Krafft 2007). In the low quality scenario only volume saturation can
occur. In the high quality scenario volume saturation need not occur and the market can
keep expanding beyond that if higher quality products can fetch higher prices. Thus, value
saturation can be expected to occur later and give rise to longer industry life cycles. As a
consequence, in TEVECON with a high quality scenario the inducement to create new sectors
would be delayed, thus leading to a lower rate of emergence of new sectors. Finally, we
have to bear in mind that the comparison we explored here is rather extreme. In any real
economic system the choice would never be between zero and a very high degree of quality
change within a sector but rather between the resources allocated to intra-sectoral quality
improvements and the creation of new sectors. Presumably, then the differences between
the rates of growth and the levels of individual welfare of the two cases would be less
pronounced and the dominance of the high quality scenario could begin for shorter times.
Furthermore, we have to bear in mind that the actual development of any real economic
system could have started in the low quality case and switched gradually to the high quality
case as society became more affluent.
4.2) PREFERENCES, DEMAND AND INNOVATION
In the previous part of the paper we studied the formation of disposable income and the
influence that efficiency and product quality can have on it. The existence of an adequate
disposable income is a necessary condition for consumers to be able to purchase the new
goods and services which are created by innovation. However, consumers will do that only if
they have an adequate set of preferences. In this section we study how different preference
systems can affect the time path of demand and of economic development. To do this we
represent two very simplified preference systems which we call progressive and
conservative. We realize that in a real economic system preferences of these different types
would be distributed within a consumer population and that they would not be immutable.
Consumers can learn and change their preferences in the course of time. Our main objective
here is simply to show that consumer preferences can affect directly demand and indirectly
the macroeconomic growth performance of the economic system.
24
Consumers with a progressive preference system value more highly new goods and services
than older ones. Consumers with a conservative preference system value more highly old
goods and services than newer ones. These two preference systems are represented with a
new parameter kpref,i in the modified demand equation (7).
i
ii
iDispiipref
t
ip
YYDDkD
,
0
, (7)
Where kpref,i is a parameter which is constant for each sector in the course of time but can
vary between different sectors. The two preference systems are then represented as
follows:
Progressive preference system: kpref, i+1 > kpref,i
Conservative preference system: kpref, i+1 < kpref,i
In different experiments we varied the degree of progressiveness or conservativeness of our
consumers by changing the Δkpref between sectors i and i+1. Thus, a large and positive Δkpref
between sectors i and i+1 indicated strongly progressive consumers while a smaller but still
positive Δkpref indicated mildly progressive consumers. Likewise, a large and negative Δkpref
between sectors i and i+1 indicated strongly conservative consumers while a smaller
negative Δkpref indicated mildly conservative consumers. In the experiments which we
carried out we calculated the number of firms in each sector Nit, sectoral demand, sectoral
disposable income, the rate of growth of employment and the rate of growth of income. The
typical results of these experiments are shown in figures 17 a, b, c, d and e for mildly
progressive preferences.
(a) (b)
25
(c) (d)
(e)
fig. 18 a, b, c, d, e: Number of firms (a), sectoral demand (b), sectoral disposable income (c),
sectoral employment and rate of employment growth (d), rate of income growth (e)
The comparison of the different preference systems is shown in figures 19 and 20, where the
slopes of the rates of growth of income and of employment are plotted for each case.
Fig. 19: Influence of the different preference systems on the rate of growth of income
26
fig. 20: Influence of the different preference systems on the rate of growth of employment
Figures 19 and 20 show that the rates of growth of income and of employment are affected
by the different preference systems. In particular, progressive preference systems tend to
give higher rates of growth of income or employment than conservative preference systems.
However, there clearly are some non-linearities, since strongly progressive preference
systems give lower rates of growth of income or employment than mildly progressive
preference systems. This occurs because as consumers allocate more and more of their
demand to emerging sectors they 'starve' mature sectors to the point where the whole
process of economic development suffers. The purpose of our paper is to show the potential
impact of the consumers’ preferences on economic development. A deeper analysis to
disentangle the complex interactions of preferences and economic development is beyond
the scope for the present paper, but on our agenda for future research.
5) SUMMARY AND CONCLUSIONS
In this paper we study the interaction between innovation and demand in the process of
economic development. Co-evolution involves the mutual feedback between innovation and
demand, which occurs by means of search activities, of investment, of the creation of
employment and income, which in the end generate demand. Amongst all the factors
involved in the above co-evolution we focus on the creation of the disposable income
required to purchase the goods and services of emerging sectors. We found that the
creation of disposable income occurs and that it is favoured, for example, by the use of
physical capital, by the growing quality of human capital and by growing product quality. In
this paper we carry out a limited number of experiments on the parameters which could be
expected to affect the interaction between innovation and demand. However, given its
highly interactive nature, our TEVECON model contains a large number of interactions which
27
could in principle affect this co-evolutionary process. For example, search activities are a
necessary requirement for the creation of innovations. Yet in TEVECON search activities rise
with accumulated demand. In turn, demand is itself affected by search activities which
contribute to raise product quality and product differentiation. Thus, the complete analysis
of all the interactions between innovation and demand goes far beyond the experiments in
this paper.
The basic dynamics of our artificial economic system is rooted in the interaction between
innovation and demand. In our previous work, following Pasinetti (1981) we had studied the
potential bottleneck in economic development induced by the imbalance between
saturating demand and continuously rising process efficiency, which we call the Pasinetti
trap. In the present paper we show that the emergence of new sectors can still make a
contribution to economic development even if complete demand saturation does not occur.
Furthermore, in addition to the emergence of new sectors we study the impact of the
growing product quality and internal differentiation sectors during their life cycle. We show
that these two processes contribute to economic development by raising disposable income,
wages and human capital with respect to a scenario in which output remains constant during
the life cycle of a sector.
In this paper we investigate the mechanisms whereby the disposable income required to buy
the new products and services of emerging sectors is created. The creation of such
disposable income is mainly due to the combination of growing efficiency of incumbent
processes and of the income effect from the investment to create the production capacity of
new sectors.
Also, we explore the impact of different preference systems on economic development. We
found that a change in the preference system has an impact on the rates of growth of
income and of employment. For example, we found that a progressive preference system, in
which consumers value the products of new sectors more than those of older ones, tends to
give higher rates of growth of income and of employment than conservative preference
systems, in which consumers value the products of older sectors more than those of new
ones.
28
The processes which we studied are part of a more general co-evolutionary pattern in which
innovation, education levels, labour force competencies, product quality and differentiation,
wages, disposable income and product prices co-evolve.
In summary, our results prove that the time path of economic development which we
observed could not have been generated by taking into account innovations alone without
making reference to the formation of an adequate demand for them. Three innovation
based processes contribute to economic development, growing productive efficiency, the
emergence of new sectors and the increasing quality and differentiation of existing products.
They need to be combined because each one individually would not suffice. However, even
the combination of these three processes needs the formation of an adequate demand to
sustain long run economic development.
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