EP06: Energy and Climate Change
Dr Jean-Francois Mercure,
Pablo Salas,
jm801@cam.ac.uk
pas80@cam.ac.uk
Lecture 6 – Innovation and economic development
Lecture 6-H2: The adoption of technology and behavioural economics
-
McFadden’s discrete choice models
Kahneman’s Prospect theory and the perception of gains and losses
Rational expectations, perfect information, representative agent and utility maximisation
Bounded rationality and access to information
Lecture 6-H1: Waves of technological change
- Waves of technological change: Kondratiev and the historical approach
- Successive waves of technology and investment
- The first and second industrial revolutions
- Access to new methods and materials: spillovers across sectors
- In the neoclassical perspective
- Solow’s residual: the contribution of technological change to growth
- Arrow’s economic implications of learning-by-doing
- Schumpeter and ‘Creative Destruction’
- The role of the innovator, the entrepreneur’s profit
- Schumpeter’s historical approach and business cycles
- Productivity change and economic development
- Endogenous vs exogenous technological progress
Lecture 6-H2: The adoption of technology and behavioural economics
- McFadden’s discrete choice models
- Intro: 2 classes of behavioural effects in economics
‘non-rational’ effects
Diversity effects
-
Agents do not follow economic rationality
- E.g. Given a repeated problem, agents do
not behave the same way every time,
i.e. their response is probabilistic
-
Agents do not behave identically
- E.g. Different agents will respond
differently, have distributed income
i.e. their response is probabilistic
-
Agents do not follow expected utility theory
U = p1x1 + p2x2 +…+ pnxn
- Prospect theory
Kahneman & Tversky (1979)
-
Agents do not have the same economic
perspectives
- Discrete choice theory
McFadden (1973)
See Ben-Akiva & Lerman (1985)
-
Classical assumption that is broken:
- Rationality, rational expectations
- The theorist assumes more knowledge
than he really has on the perspectives of
the representative agent
-
Classical assumption that is broken:
- Representative agent
- The theorist assumes more knowledge
than he really has on the perspectives
of diverse agents
Lecture 6-H2: The adoption of technology and behavioural economics
- McFadden’s discrete choice models
- How to integrate a diversity of agents: the binary logit
-
The theory can use either a random Utility maximisation or a generalised Cost minimisation (i.e. disutility)
It goes as follows: we define the random utility, which is distributed according to agent diversity
V is the systematic part (the mean)
ε is the distributed (random) part
Can be written in terms of many socio-economic components
We must find the probability (or proportion of cases) where the utility of option i is
greater than the utility of option j
Std(ε):
Assuming that U follows an extreme value distribution,
Solution: a logistic curve:
See Ben-Akiva & Lerman, ‘Discrete Choice Analysis’ (1985)
Lecture 6-H2: The adoption of technology and behavioural economics
- McFadden’s discrete choice models
- How to integrate a diversity of agents: the binary logit
Revealed preferences integrates agent diversity
Assuming that U follows an extreme value distribution,
Solution: a logistic curve:
See Ben-Akiva & Lerman, ‘Discrete Choice Analysis’ (1985)
Lecture 6-H2: The adoption of technology and behavioural economics
- McFadden’s discrete choice models
- How to integrate a diversity of agents: the multinomial logit
We can define a discrete choice model for a choice between several options.
-
Here, one of the distributions corresponds to the maximum of all the alternatives
We carry out the same calculation, and we obtain:
It assumes however that agents have perfect knowledge of all their options
See Ben-Akiva & Lerman, ‘Discrete Choice Analysis’ (1985)
Lecture 6-H2: The adoption of technology and behavioural economics
- Kahneman’s Prospect theory and the perception of gains and losses
-
-
Expected utility theory is
- Linear in probability
- E.g. with x as outcome, p as probability,
U = p1x1 + p2x2 + p3x3 +…+ pnxn
- Absolute, not relative
- Decisions are made on final states, not on changes of state
- Symmetrical gains vs losses (a loss is identical to a non-gain)
- Both are risk-averse
Prospect theory:
- People overweight outcomes that are certain
-
Relative to status quo (or starting situation or perspective)
- E.g. (4000, .80) and (3000)  (1000, .80)
Gains are risk averse, losses are risk-taking
- E.g. (4000, .80) and (3000) ≠ (-4000, .80) and (-3000)
Kahneman & Tversky, Econometrica, Vol. 47, No. 2. (1979), pp. 263-292
Lecture 6-H2: The adoption of technology and behavioural economics
- Bounded rationality and access to information
- About rational expectations, perfect information, representative agent and
utility maximisation
To help bring the abstract ideas about energy efficiency costs, benefits, barriers and drivers down to earth, consider a small house in London: my house,
comprising the upper two floors of a former collective housing block, sold under Mrs Thatcher’s property reforms. It had old wood-framed windows, filament
lights and central heating powered by a gas boiler past its prime that fed water to a hot tank.
I checked there was some insulation in the loft and on the tank. I soon fitted compact fluorescent lights – where they would fit (a ‘hidden cost’ eliminated by
new designs a few years later) – and eventually (inertia – a ‘behavioural’ feature) got around to buying a new ‘A-rated’ fridge and separate freezer. By that
time, they were clearly labelled (reducing the ‘hidden cost’ of trying to find out what was most efficient – and also tweaking my ‘hidden benefit’ driver, the
label displaying to everyone I had gone for the best). Anyway, by that time, so many people were buying A efficiency fridges that they were almost as cheap as
others (‘economies of scale’).
For a long time, I didn’t get round to the rest (inertia again – not a reasoned weighing of costs and benefits). However, one day the local council announced
that it was going to do a major windows replacement. Workmen came in – a disruption (‘hidden cost’) – and soon I had a new set of gleaming, double-glazed
and high-efficiency windows, together with a hefty bill to pay back over several years. Left to myself, I would never have found the capital (the upfront cost
barrier) or organised it (transaction cost), and the savings probably haven’t yet paid back the cost. But the place is less prone to draughts, more secure against
break-ins and has less noise from the street (all ‘hidden benefits’). By then, however, I had rented out the house and the tenants get many of these benefits
(‘split incentives’).
Two years later I received a letter: on 16 September, unless I declined, workers would arrive to install much deeper insulation in the loft. It turned out I only
had two inches – at least six was recommended. The council would pay, not me; I just had to clear the loft. As an exercise in behavioural nudging, combined
with a bit of subsidy, it was masterful. To get out of it, I’d have to refuse. (How could I possibly do that?) Rising energy prices also helped the tenants consent to
the disruption. It took me two days to clear the loft properly and put things back afterwards (a sizeable ‘hidden cost’), but I found some valuable things –
including an unused stereo system (!) – and at long last had everything there ordered and sorted, easy to get at again, and with some nice old stuff also given
away to charity (‘hidden benefits’, widely shared), followed by noticeably lower energy bills – the classical benefit, but almost entirely irrelevant to the actual
decision.
Some years later, I have no hesitation in pronouncing the cost-benefit balance to be positive, but if the local council hadn’t butted in, I would probably never
have got around to it. I did eventually replace the ancient boiler with a smaller, neater combi condensing one (aided by a small subsidy), which also meant I
could remove the old tank – some chunky metal for recycling and a whole new cupboard space for me (more hidden benefits, this time from technical
progress).
Energy consumption (and costs and emissions) are now way down. Due to my own rational, cost-benefit approach to decision-making? You must be joking –
and I was Chief Economist at the Carbon Trust. A final, bemusing thought is that some of the simplistic economic models don’t only assume free market
economies to be ‘optimally efficient’, they also assume that changes are reversible: that an efficiency measure that may be cost-effective at high energy prices
will reverse if the energy price falls. More sophisticated economic models allow for capital lifetimes, typically a few decades. I fully expect my new windows to
be there for decades, and they won’t be replaced by worse ones. As for the loft, I expect the insulation to be there for as long as the house (probably a century
or more). Even if energy were free, you wouldn’t find me removing it.
Grubb M., Planetary Economics Ch 4 p. 143 (2014)
Lecture 6-H2: The adoption of technology and behavioural economics
- Bounded rationality and access to information
- E.g. Agent diversity in car markets across the globe
UK
-
USA
Consumer diversity is high, and is country-dependent.
Marketing research generally make full account of agent diversity (market segments)
Marketing research + socio-anthropological work = car purchases are socially determined
Therefore 1 size fits all approach to policy-making for influencing consumer choice would not work
Mercure & Lam, http://arxiv.org/abs/1411.2384 (2015)
Lecture 6 – Innovation and economic development
Lecture 6-H1: Waves of technological change
- Waves of technological change: Kondratiev and the historical approach
- Successive waves of technology and investment
- The first and second industrial revolutions
- Access to new methods and materials: spillovers across sectors
- In the neoclassical perspective
- Solow’s residual: the contribution of technological change to growth
- Arrow’s economic implications of learning-by-doing
- Schumpeter and ‘Creative Destruction’
- The role of the innovator, the entrepreneur’s profit
- Schumpeter’s historical approach and business cycles
- Productivity change and economic development
- Endogenous vs exogenous technological progress
Lecture 6-H1: Waves of technological change
- Waves of technological change: Kondratiev and the historical approach
- Successive waves of technology and investment
Biotech
Internal
combustion
engine
IT
Electricity
Steam
Textiles
-
Kondratiev Waves: Waves of technological development, approx 55 years long
Each wave of technological change was tied to waves of economic development and social change
The end of each wave was tied to social, political and economic turbulence
The level of R&D investment per sector is indicative of where activity is in the economy:
- Currently biotech is leading in terms of R&D investment
Grubb, Planetary Economics, Ch 11 p420 and Ch 9 p 321 (2014)
See also Freeman & Louça (2001) and C. Perez (2001)
Lecture 6-H1: Waves of technological change
- Waves of technological change: Kondratiev and the historical approach
- The first industrial revolution
How does technological change influence the global economy?
Investments create productivity growth and price declines that propagate across
the economy
-
Productivity change and cross-sectoral spillovers!
Take the first industrial revolution: Textiles and cotton spinning
- Investment in a sector leads to investment in a myriad of connected sectors
- E.g. investment in textiles spinning technology -> investment in iron industry + water power
-> investment in coal mining -> investment building canals & roads -> …
- Prices of factors of production decline
- E.g. High iron demand in textiles -> investments in iron industry -> learning-by-doing
-> lower price of iron -> low cost iron available for other uses
- Re-defines the ‘design space’: lower cost factors of production enable new possibilities previously
not possible
- E.g. Investment in building canals -> low cost transport + coal + iron -> building other types
of factories -> other goods become cheaper
- New organisation of labour, management practices
- Transition of labour from agriculture towards industry, economies of specialisation
- General price levels declining (textiles, transport, coal, iron) corresponding to higher productivity,
enables access to more with the same income
- E.g. we see the development of a middle class
- This sets the building blocks for the next wave of innovation:
- The steam engine, built with low cost coal, iron and the development of engineering
- The steam engine stays in the background as a crazy innovation for a long time
Freeman & Louça, As time goes by, (2001)
Lecture 6-H1: Waves of technological change
- Waves of technological change: Kondratiev and the historical approach
- The first industrial revolution
Example: coal, coke and the production of metal iron
-
-
-
-
Earlier in history (since the iron age) iron was produced by mixing iron ore with charcoal (carbon) and
combusting at high temperatures
- This was limited by the availability of vast quantities of wood to turn into charcoal
Coal could not be used to produce quality iron
Coke is derived from coal by heating it to high temperatures and outgassing liquid and oily
hydrocarbons
Engineers discovered that coke can replace charcoal:
- this expanded the carbon resource for iron production by a
huge amount
- The production of coke generates combustible gas as by-product:
Town gas
Coke is still used nowadays to reduce iron ore,
- e.g. Fe3O4 + 2C -> 3Fe + 2CO2
- Therefore coal is not just used for heat!
The development of the iron and coal industries were tied together
Lecture 6-H1: Waves of technological change
- Waves of technological change: Kondratiev and the historical approach
- Access to new methods and materials: spillovers across sectors
Example: changing productivity with R&D investment:
Sakichi Toyoda and textiles technology in Japan







Development of the weaving device,
importation of European technology:
human power
Development of successive versions of
the automatic spinning technology
Development of successive versions of
the automatic weaving loom
Each successive design reduced labour
requirement and increased speed of
production
Productivity increased by a factor ~2
each generation
Within ~45 years of R&D
productivity changed by approx.
a factor of > 10
Toyoda son sold a patent to the UK,
re-invested profits
and created what is
now Toyota…
The Toyoda Commemorative Museum of Industry and Technology, Nagoya, Japan,
http://www.tcmit.org/english/exhibition/textile.html
Lecture 6-H1: Waves of technological change
- Waves of technological change: Kondratiev and the historical approach
- The second industrial revolution
How does technological change influence the global economy?
-
Productivity change and cross-sectoral spillovers!
Take the second industrial revolution: the steam engine, railways, mechanisation
- The steam engine was initially used first (among other things) to drain coal mines
- Revolution in transport of goods and people
- Mass availability of low cost transport over long distances
enables new types of trade, business models, modes of living
- The availability of the steam engine, machine tools and the engineering industry
- Using steam power for mechanical work
- Many applications of industry becoming mechanised
- Replacing human/animal power for steam power
- Using machines to make machines
- Steam ships and shipping overseas (See Geels, Research Policy, 2002)
Freeman & Louça, As time goes by, (2001)
Lecture 6-H1: Waves of technological change
- Waves of technological change: Kondratiev and the historical approach
- Access to new methods and materials: spillovers across sectors
How does technological change influence the global economy?
-
You can see this similarly to the development of branches in a tree
E.g. The input-output table
representing cross-sectoral exchanges
-
If relative prices change, industry
re-structures and the table changes
Productivity increases changes IO
coefficients
-
Technology developments branch out
The main branch size is an analogy to sectoral growth,
availability and price declines (e.g. coal and iron)
Branches feed and enable the growth of an increasing
technological diversity
Freeman & Louça, As time goes by, (2001)
Lecture 6-H1: Waves of technological change
- In the neoclassical perspective
- Solow’s residual: the contribution of technological change to growth
Production function:
-
-
Assuming constant returns to
scale (neoclassical model)
Solow determined that only 1/8
of productivity growth was
attributable to increased capital
per man-hour
=> 7/8 of productivity increase
is due to technological change
(Think of Sakichi Toyoda!)
Solow, The Review of Economics and Statistics, (1957)
Lecture 6-H1: Waves of technological change
- In the neoclassical perspective
- Arrow’s economic implications of learning-by-doing
Now [knowledge] trend projections, however necessary they may be in
practice, are basically a confession of ignorance, and, what is worse from
a practical viewpoint, are not policy variables. (Arrow 1962)
-
Arrow uses aggregate cumulative investment to construct a production function
The productivity of capital increases (the labour required per unit capital decreases)
He derives employment of labour and capital
Obtains a production function with increasing returns to scale
- Indicates endogenous growth due to knowledge accumulation
Concludes that full employment is only one possibility, but that the solution admits the
possible unemployment of either labour or capital
It means that the economy can undergo cycles
Old capital, with higher labour requirements, is scrapped when its cost of operation is
higher than its income
Arrow K., The Review of Economic Studies, Vol. 29, No. 3 (1962), pp. 155-173
Lecture 6-H1: Technological change and economic development
- Schumpeter and ‘Creative Destruction’
- The role of the innovator, the entrepreneur’s profit
Schumpeter: father of evolutionary economic theory (without specifically aiming at that)
- Schumpeter 1934: The theory of Economic Development
Sets the stage for an explanation of economic change through entrepreneurial activity:
1- The entrepreneur finds a new way to combine factors of production at lower costs
2- He borrows funds to finance his enterprise
3- He applies his innovation, and if successful, reduces costs compared to competitors
4- For a time, the price remaining nearly unchanged, his lower production costs earns him
a profit in comparison to his competitors, and he repays his loan over time
5- His competitors catch up, the price declines and reaches the entrepreneur’s costs,
making his profit vanish
6- The entrepreneur ventures into other innovations and borrows more funds
- Credit plays an essential role: the finance of R&D and innovation
Initial Price
Cost/Price
-
Market Price
Entrepreneur’s
Cost
Entrepreneur’s
Profit
Final Price
Time
Schumpeter, The theory of economic development (1934)
Lecture 6-H1: Technological change and economic development
- Schumpeter and ‘Creative Destruction’
- Schumpeter’s historical approach and business cycles
-
-
-
According to Schumpeter, R&D investment lead to economic development through the role of the
entrepreneur. Economic development corresponds to productivity growth and relative price
declines, enabling higher levels of consumption for the same income.
This is done through perpetually challenging the state of technology
The implication of Schumpeter’s idea means that economic development takes place at the
expense of breaking old socio-technical regimes and creating new ones:
this was called ‘Creative Destruction’
- E.g. The internal combustion engine changed patterns of mobility and displaced the steam
engine
- The telephone replaced the telegraph
- The smart phone displaced the old landlines, combining telecom with computing
- Computerising the firm decentralised management systems (e.g. emails)
Credit plays a central role in Schumpeterian economics:
- The entrepreneur is not the financier, i.e. he risks someone else’s money (e.g. bank’s)
- Entrepreneurial activity takes place in ‘clusters’
- Clusters are due to connections between innovations, which occur within specific
sectors
- Therefore economic development occurs in clusters, and this leads to business cycles
=> Economics out of equilibrium
=> Entrepreneurial activity leads to economic booms and crashes
=> Speculation on technology leads to bubbles and stock market crashes
(e.g. the IT bubble)
Schumpeter, The theory of economic development (1934)
See also Carlota Perez, Technological Revolutions and Financial Capital (2001)
Lecture 6-H1: Technological change and economic development
- Schumpeter and ‘Creative Destruction’
- Technology finance and business cycles
-
Perez associates financial crises historically with technology developments and speculation that
they have aroused in financial markets (e.g. the canal mania, railway mania, IT bubble)
Technology developments slowly emerge, then attracts attention of financiers, then leads to
speculative behaviour, to a financial crash, and afterwards to a technology consolidation phase
Carlota Perez, Technological Revolutions and Financial Capital (2001)
Lecture 6-H1: Technological change and economic development
- Productivity change and economic development
- Endogenous vs exogenous technological progress
Exogenous growth models
-
Productivity A(t) is specified ‘in advance’,
independently of economic activity
-
In a utility optimisation framework, it gives a
tendency to agents not to invest into R&D since
productivity growth happens on its own,
‘like manna falling from heaven’
-
However, it keeps the model between clear
bounds with unique solutions
(i.e. not path-dependent)
Endogenous growth models
-
Productivity increases take place in terms of
economic activity through investments in
capital and R&D
Capital
investments
Productivity
Growth
Increased
output
Price
Declines
Lecture 6: Further reading
- Following this lecture, please read:
- Michael Grubb, Planetary Economics (2014) Chapters 9, 10 ,11
Lecture 6: References
Arrow K., The Economic Implications of Learning by Doing, The Review of Economic Studies, Vol. 29, No. 3 (1962), pp. 155-173
Ben-Akiva & Lerman, ‘Discrete Choice Analysis’, MIT press (1985)
Freeman & Louça, As time goes by, Oxford (2001)
Grubb, Planetary Economics, Routledge (2014)
Kahneman & Tversky, Prospect Theory: An Analysis of Decision under Risk, Econometrica, Vol. 47, No. 2. (1979), pp. 263-292
Mercure & Lam, http://arxiv.org/abs/1411.2384 (2015)
Carlota Perez, Technological Revolutions and Financial Capital, Edward Elgar (2001)
Schumpeter, The theory of economic development, Transaction Publishers (1934)
Solow R., Technical Change and the Aggregate Production Function, The Review of Economics and Statistics, Vol. 39, No. 3
(1957), pp. 312-320