A central proposition of New Growth theory is that, unlike land and capital, knowledge is not subject to diminishing returns.
Indeed, the development of knowledge is seen as a key driver of economic development. The implication is that, in order to develop, economies should move away from an exclusive reliance on physical resources to expanding their knowledge base, and support the institutions that help develop and share knowledge.
Governments should invest in knowledge because individuals and firms do not necessarily have private incentives to do so. For example, while knowledge is a merit good, and acquiring it does not deny anyone else that knowledge, its usefulness to individuals and firms may be undervalued, and yet knowledge can generate increasing returns and drive economic growth. Government should, therefore, invest in human capital, and the development of education and skills. It should also support private sector research and development and encourage inward investment, which will bring new knowledge with it.
Because ‘public’ investment in social capital is subject to market failure, New Growth theorists argue that government should allocate resources to compensate for this failure.
Essential utilities like electricity, gas, and water are natural monopolies, and in many countries are provided by the public sector. However, if these utilities are under-supplied due to inadequate public funds, the private sector will suffer and growth will be limited. This is because the industrial sector relies on energy and water for its production and distribution, without which it will not produce efficiently or competitively. The accumulation of private capital, therefore, depends up the correct level of expenditure by government.
Similarly, New Growth theorists argue that government should also finance, or seek finance for, infrastructure projects, such as road, rail, sea, and air transport. Such projects involve the creation of quasi-public goods, and the theory of market failure suggests that they would be ‘under-supplied’ without government. The huge fixed costs and the difficulty of charging users prevents the private sector supplying, and the state may choose to act like a producer and financier, and provide necessary legislation for and co-ordination of such projects.
These projects also generate positive externalities, and as such justify government involvement. For example, an improved infrastructure increases the likelihood of tourist revenue as well as reducing production costs.