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No. 10: Endogenous Innovation and Growth: Implications for Canada

by Pierre Fortin and Elhanan Helpman Université du Québec à Montréal and the Canadian Institute for Advanced Research, and Tel Aviv University and the Canadian Institute for Advanced Research, respectively. Under contract to Industry Canada as part of the Science and Technology Review, August 1995


While Canada enjoys one of the five highest levels of real income in the world today, economic growth in the country has slowed down since 1973. Labour productivity, as a contributing factor to economic growth, accounted for about 60 percent of the overall economic growth in both the 1961–1973 period and in the post-1973 period when overall economic growth slowed. The dominance of labour productivity in Canada will most likely become even stronger. Labour productivity growth, and not demographic trends, will continue to be the dominant determinant of growth in Canada in the future.

If the labour productivity slowdown was the major cause of the decline in the growth rate of real income per capita beginning in the first half of the 1970s, the next logical question is why annual labour productivity gains have been smaller ever since. In an effort to explain why labour productivity gains have slowed, it is suggested that labour productivity growth is derived from two sources: capital accumulation and technological progress, as measured by the growth in total factor productivity (TFP).

Observed labour productivity slowdown in Canada after 1973 was not the result of a decline in the rate of capital accumulation: the trend growth rate of capital per worker did not change significantly between the two periods 1961–1973 and 1974–1993. The productivity slowdown was rather the result of other developments that have translated into a decline in the growth of TFP.

Looking at human capital accumulation, it is concluded that public policies to encourage investment in human capital can enhance efficiency and speed up the economy's growth rate. The paper also explores the implications of gains made possible through "learning by doing" and demonstrates how investment in R&D is a mechanism through which labour productivity can rise.

The mechanisms through which investment in R&D can influence productivity growth, within models of endogenous growth, are then explored. For privately funded R&D to take place, an economic environment that protects intellectual property rights must exist in a way that allows firms to enjoy the fruits of their R&D efforts. Also, some form of increasing returns and lack of perfect competition (monopoly power) are necessary for R&D investment.

Theoretically, investment in R&D can have positive or negative effects on output growth. Positive spillovers arise when the social benefits to investment exceed the costs. Negative effects are also possible, however, arising from the destruction of products and profits as R&D investment creates new products and processes to replace existing ones. On balance, in Canada, significant R&D spillovers appears to exist across firms and industries. As a result, the social rate of return on R&D is higher that the private rate of return by a factor that varies from two to five.

It follows from the above evidence that Canada does not invest enough in R&D. This is in part due to the existence of positive externalities. But also, Canada is a small open economy where there are plenty of natural resources which are a poor substitute for highly skilled labour. This leads the economy to specialize in resource-intensive sectors and to invest too little in R&D.

Therefore, there is an economic rationale for subsidizing investment in R&D in Canada. Subsidization of R&D, however, must be carefully assessed to reflect the true extent of the spillover effects. Also, while R&D subsidies may be desirable, output subsidies for sectors that invest in R&D may be detrimental.

Investment in R&D can also have an impact on the labour markets. In particular, productivity growth that is driven by inventive activities can raise or reduce the long-run level of unemployment. This important question has received very little attention. More research is required on the impacts of investment in R&D on unemployment and on the types of education and training that would be optimal.

International economic relations can play an important role in shaping a country's economic attributes. Trade and foreign direct investment generate positive spillovers via the flows of knowledge that they cultivate. In addition, trade will lead firms to specialize and reduce the extent to which the same kinds of research are duplicated in different countries. Further, servicing a larger market raises the return to R&D, therefore, raising the level of R&D undertaken. There are, however, potentially negative effects of trade on investment in R&D arising from the increased competition that firms face in international markets and the resulting price discipline that this brings. But on balance, the available empirical evidence supports the view that trade has a favourable impact on productivity.

In conclusion, policies encouraging the accumulation of human capital, directly supporting R&D activity and ensuring access to international knowledge and markets can improve growth prospects. However, in each case, there are possible negative effects that do not guarantee a higher level of welfare. Therefore, both costs and benefits must be considered in the development of economic policies in these areas.

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