Distance to Frontier, Selection, and Economic Growth
GAICIL Insights
What builds a catching-up economy can imprison a frontier one.1 Distance to Frontier, Selection, and Economic Growth, by Daron Acemoglu, Philippe Aghion and Fabrizio Zilibotti, analyzes an economy where firms both innovate and adopt technologies from the world technology frontier. Leaders often feature younger firms and more churning; followers emphasize investment and long-term relationships. The model accounts for this pattern and weighs each strategy's costs and benefits.
Selection is the mechanism. Selecting high-skill managers and firms matters more for innovation than for adoption. Approaching the frontier, there is less room for copying established technologies, so selection grows more important. Far from the frontier, countries pursue an investment-based strategy, with long-term relationships, large and older firms, high investment and little selection. Closer to the frontier, there is an equilibrium switch to an innovation-based strategy with short-term relationships, younger firms, less investment and better selection of managers and firms. Copying rewards loyalty; inventing rewards sorting.
Policy implications are nuanced. Relatively backward economies may switch out of the investment-based strategy too soon. Policies such as limits on product market competition or investment subsidies, which encourage that strategy, may help in the short run. They may carry significant long-run costs: they make it likelier a society becomes trapped in the investment-based strategy and fails to converge to the frontier. Today's scaffolding can become tomorrow's cage.
The tradeoff is central. Policies that help catching up may later hinder innovation. An economy relying too long on incumbents and long-term relationships may lack the selection frontier innovation needs. Timing the transition is a critical policy challenge, and governments rarely notice the moment has passed.
Now the AI angle. AI leadership requires the innovation-based strategy. Economies leading in AI should feature younger firms, more churning and better talent selection. Economies protecting incumbents and limiting competition may struggle at the AI frontier. The AI frontier is hostile territory for economies organized around permanence.
Selection drives AI innovation. AI depends on identifying and empowering the most capable managers, researchers and firms. Economies with dynamic labor and capital markets that let talent and resources flow to the best performers are better positioned. Short-term relationships and firm turnover facilitate this selection. Job hopping, from this angle, is a selection mechanism.
Catching-up economies get guidance and a warning. Adopting AI developed elsewhere can proceed with investment-based strategies relying on existing firms. As they approach the frontier, they must shift toward innovation-based strategies. Protecting incumbents too long risks a trap.
The trap reshapes industrial policy. Favoring national champions or limiting competition may help early but can lock economies into strategies impeding frontier innovation. Such policies should come with clear exit points and attention to long-run consequences. A sunset clause may be the most important line in a national champion policy.
Firm strategy follows. Frontier firms benefit from structures supporting selection and experimentation. Younger, more flexible firms may hold advantages in frontier innovation, helping explain why many AI breakthroughs come from newer firms.
Cross-country differences in economic organization become legible. The marked differences between leaders and followers are equilibrium responses to distance from the frontier, a lens for interpreting different national approaches to AI.
At bottom, appropriate economic strategies depend on distance to the frontier, and selection matters more as economies approach it. Investment-based strategies suit followers; innovation-based strategies suit leaders. As AI defines the new frontier, economies seeking leadership will need the dynamism, churning and selection innovation requires, avoiding policies that trap them in strategies suited to an earlier stage.
Governments building AI champions might start here: write the exit date into the support package on day one. The model's warning is that an economy can be helped up the ladder by the same policies that later keep it from climbing to the top.
Introduction
We analyze an economy where firms undertake both innovation and adoption of technologies from the world technology frontier. The selection of high-skill managers and firms is more important for innovation than for adoption. As the economy approaches the frontier, selection becomes more important. Countries at early stages of development pursue an investment-based strategy, which relies on existing firms and managers to maximize investment but sacrifices selection. Closer to the world technology frontier, economies switch to an innovation-based strategy with short-term relationships, younger firms, less investment, and better selection of firms and managers. We show that relatively backward economies may switch out of the investment-based strategy too soon, so certain policies such as limits on product market competition or investment subsidies, which encourage the investment-based strategy, may be beneficial. However, these policies may have significant long-run costs because they make it more likely that a society will be trapped in the investment-based strategy and fail to converge to the world technology frontier.
Takeaway
There are certain marked differences in the economic organization of technological leaders and technological followers. While technological leaders often feature younger firms and greater churning, technological followers emphasize investment and long-term relationships. In other words, while technological leaders follow an innovation-based strategy, technological followers adopt an investment-based strategy of growth. In this paper, we have proposed a model which accounts for this pattern, and also evaluates the pros and cons of investment-based and innovation-based strategies. In our economy, managers engage both in copying and adopting technologies from the world frontier and in innovation activities. The selection of high-skill managers is more important for innovation activities. As the economy approaches the technology frontier, selection becomes more important. As a result, countries that are far away from the technology frontier pursue an investment-based strategy, with long-term relationships, high average size and age of firms, large average investments, but little selection. Closer to the technology frontier, there is less room for copying and adoption of well-established technologies, and consequently, there is an equilibrium switch to an innovation-based strategy with short-term relationships, younger firms, less investment and better selection of managers. The sequence of investment-based strategy followed by an innovation-based strategy is not only a feature of the equilibrium, but also of the socially-planned economy. However, societies may switch out of the investment-based strategy too soon or too late.1
A standard appropriability effect, resulting from the fact that firms do not internalize the greater consumer surplus they create by investing more, makes the switch too soon. Whereas the presence of retained earnings that incumbent managers can use to shield themselves from competition makes the investment-based strategy persist for too long. When the switch is too soon, government intervention in the form of policies limiting product market competition or providing subsidies to existing firms may be useful because they encourage the investment-based strategy. Equally interesting, we find that retained earnings may shield insiders so much that some societies may never switch out of the investment-based strategy, and these societies never converge to the world technology frontier. The reason is that they fail to take advantage of the innovation opportunities that require managerial selection. This means that policies encouraging investment-based strategies might also lead to non-convergence traps.
The optimal policy sequence for economic growth is therefore a set of policies encouraging investment and protecting insiders, such as anti-competitive policies at the early stages of development, followed by more competitive policies. Such a sequence of policies creates obvious political economy problems. Beneficiaries of existing policies can bribe politicians to maintain these policies. Moreover, these groups, in our model the capitalists, will be politically powerful precisely because they have economically benefited from the less-competitive policies in place. Therefore, the model illustrates how a well-meaning attempt to speed up convergence may lead to a political economy trap. Interestingly, such traps are more likely when the underlying political institutions are weak, making politicians easier to capture. In this context, the model also sheds some light on the debate about whether government intervention should be more prevalent in less developed countries. The answer suggested by the model is that, abstracting from political economy considerations, there is a greater need for government intervention when the economy is relatively backward. But unless political institutions are sufficiently developed, or become developed in the process of economic growth, to impose effective constraints on politicians and elites, such government intervention may lead to the capture of politicians by groups that benefit from government intervention, paving the way for political economy traps. Even though much of the emphasis in this paper is on cross-country comparisons, the same reasoning also extends to cross-industry comparisons.
In particular, our analysis suggests that the organization of firms and of production should be different in industries that are closer to the world technology frontier. More generally, cross-industry differences in the internal organization of the firm and the type of equilibrium financial and employment relationships, and the political economy implications of these differences, constitute a very interesting, and relatively underexplored, area for future research.
Notes
- Daron Acemoglu, Philippe Aghion & Fabrizio Zilibotti, Distance to Frontier, Selection, and Economic Growth, 4 J. Eur. Econ. Ass'n 37 (2006), https://doi.org/10.1162/jeea.2006.4.1.37. Takeaway source: Conclusion, reproduced from a free author or repository copy (working-paper version). ↩
Cite as: Daron Acemoglu, Philippe Aghion & Fabrizio Zilibotti, Distance to Frontier, Selection, and Economic Growth, 4 J. Eur. Econ. Ass'n 37 (2006), https://doi.org/10.1162/jeea.2006.4.1.37
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