New Growth Theory

New Growth Theory

New Growth Theory is an economic framework that explains long-run economic growth as the result of purposeful human activities—entrepreneurship, innovation, knowledge accumulation, and technological change—rather than external, exogenous forces. It argues that ongoing profit-seeking and competition drive continuous improvements in productivity and rising real GDP per person.

Key takeaways

• Growth is endogenous: innovation, human capital, and knowledge drive sustained economic expansion.
• Competition and shrinking profits push firms and individuals to innovate to preserve or expand returns.
• Knowledge is treated as a key growth asset: it can be expanded, shared, and does not exhibit the same diminishing returns as physical capital.
• Policy can matter: public investment in education and R&D helps overcome underinvestment in knowledge and its positive spillovers.

How the theory works

New Growth Theory emphasizes mechanisms that make growth self-sustaining:
* Profit incentives motivate entrepreneurs, researchers, and firms to search for better methods and new products.
The amount of innovation depends on how many people are searching and how intensely they search—human capital and incentives matter.
Knowledge is a partially nonrival, accumulable input: using or sharing knowledge does not necessarily diminish its value and can produce increasing returns at the economy or industry level.
* Because knowledge generates externalities (benefits beyond the original investor), private markets may underinvest in its creation without public support.

Example: internal innovation and human capital

Firms can apply the theory by incubating internal projects and investing in employees’ skills. For example:
* Large companies may allow staff to devote time to independent projects, effectively creating internal startups that can produce new products or services (common in software and app development).
The expectation of profit—both for employees and the firm—encourages exploration and innovation.
Sustained investment in training and research capacity increases the pool of people capable of generating new ideas and technologies.

Policy implications and special considerations

Because knowledge has spillovers and is often undervalued by individual firms, proponents argue that:
* Governments should support education, training, and public R&D to raise the economy’s capacity for innovation.
Public incentives (grants, tax credits, infrastructure for research) can align private incentives with broader social returns.
Policies that foster entrepreneurship and knowledge diffusion (e.g., intellectual-property regimes balanced with diffusion, university–industry links) help translate human capital into sustained growth.

Further reading

• Paul M. Romer, “Increasing Returns and Long-Run Growth” (1985).
• Xavier Sala-i-Martin, “15 Years of New Growth Economics: What Have We Learnt?” (2002).