Executive Summary
The key objective of economic policy is to achieve high and rising levels of material well-being – proxied by per capita real income. Per capita income growth results from an evolutionary process of economic development. Economic development is driven by entrepreneurs in business. They grope forward in a radically uncertain environment seeking out profit opportunities. In doing so, they develop profitable new and improved products (goods and services) and methods of producing and marketing them ‑ i.e., they innovate.
Entrepreneurs are motivated by the intrinsic satisfaction innovation yields, by social approval and by material rewards. In particular, profit provides entrepreneurs with the incentive and means to focus on socially valuable innovation and so to add to real output. A succession of innovations leads to successive increases in output per capita – in other words, leads to economic growth. Thus innovation is essential to economic growth.
In a modern economy, producing even relatively simple products requires a complex web of knowledge, institutions, skills, networks and other capabilities for their production. These capabilities are highly differentiated and product specific, so that countries that look alike in their factor endowments actually produce different products.
When they innovate, entrepreneurs build off the existing complex web of interdependent capabilities, and in innovating, create new, somewhat different knowledge and capabilities. This in turn creates a new higher foundation of capabilities and knowledge, laying the foundation for more innovation and economic growth. As a result, economic development is systemic in nature and path dependent. It results in an evolutionary transformation of the product mix and the production structure.
There are two implications of this analysis. First, the highly differentiated nature of products and capabilities means that areas of comparative advantage will be highly differentiated. This means that even a tiny country like New Zealand can realistically aspire to retaining and developing a sustainable comparative advantage in a few areas.
Second, where a country has developed a comparative advantage, it is likely that it has developed a myriad of related, difficult to replicate, world-class capabilities and resources. It is also likely in future that it will develop new world‑class capabilities in products adjacent to its current comparative advantage. These capabilities will be difficult for a country without a similar comparative advantage to replicate.
For New Zealand, this puts a particular focus on the food and fibre based industries, together with their related and supporting industries.
There is an extensive literature on the nature of capabilities that are important to economic growth. These are summarised in MED's productivity model (see Annex 3). Broadly, there are two sorts of capabilities – capabilities of individual economic agents (such as skills) and capabilities that relate to the relationship between economic agents.
One key such capability is a well functioning market. The market mediates the process of economic development. It resolves the enormously complicated problem of aligning the activities of all the actors in the economy.
However, in a modern market economy, the market is neither natural nor perfect. Ongoing government action is necessary to create and sustain a market which fosters socially productive innovation. It should seek to give entrepreneurs the incentive to compete on those margins, and those margins alone, that are socially desirable. It also should seek to ensure that they have available to them the capabilities they need to innovate. At the same time, it should do so in a way that recognises the incentives and uncertainties it faces.
Thus the real question for the government is not whether to intervene, but where, how and in what circumstances to intervene.
In New Zealand, as in other developed economies, there is a complex web of government intervention aimed at making markets work effectively to promote high and rising levels of per capita incomes. The New Zealand economy is regarded as having institutional settings that are relatively conducive to promoting good economic growth. In addition, the government intervenes in a variety of ways for economic and non-economic reasons. The design of these interventions has the potential to impact for good or ill on the operation of markets, including in particular the market for innovation.
However, government action to maintain and improve the market raises the risk of rent-seeking (i.e., when an individual, organization or business seeks to make money by manipulating the economic and/or legal environment rather than by trade and production of wealth1), either by those in government or by those who can influence the government.
Thus an assessment of whether and how to intervene in any particular case involves an assessment of the costs and benefits of intervening.
For broad-based economy-wide policies, like competition policy, there is often good evidence for designing policy, and the risks of rent-seeking can often be contained. While only small improvements in these policies are likely to be possible in New Zealand, their broad applicability means that they are likely to have substantial effects and are worth pursuing.
Fine‑grained policies, such as much of industry policy, are more problematic, for two related but distinct reasons. First, often the only robust source of evidence to design policy is the industry itself, making rent seeking more of an issue. Second, both the design and implementation of such policies often need to be customised to the particular circumstances, which means that those doing the design and implementation need to have the competence required to understand both the reason for intervening and the relevant part of the economy. Such skills are rare, meaning that we have to be quite selective in adopting such policies.
However, because the multiple capabilities required for achieving new areas of comparative advantage will be highly specific, intervention at this more detailed level is likely at times to be important for fostering growth. In addition, the need to engage with industry raises the scope for coordinated action which can yield gains that are otherwise unattainable.
In the end the decision on where and how to intervene must involve a judgement about the various benefits and costs involved. There are likely to be circumstances where it is beneficial to introduce fine-grained policies that cannot be justified on the basis of robust statistical evidence. At the same time, the information needs and rent-seeking opportunities associated with such intervention, and the skills need to implement them effectively, mean that a selective approach and careful policy and institutional design is essential if the benefits of such policies are to outweigh their costs.
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