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1 KOREWORKI NG PAPERSI N BUSI NESSAND ECONOMI CS FROM NECESSI TI ESTO I MAGI NARY WORLDS: STRUCTURALCHANGE, PRODUCTQUALI TYAND ECONOMI CDEVELOPMENT by * Pi erpaol osavi o i &Andr easpyka * Pi erpaol osavi o i, I NRAGAEL, Uni ver s i épi er r emendè s Fr ance, BP47, 38040Gr enobl e, Fr anceemai l : pi er paol o. s avi o f r GREDEG CNRS, 250RueAl ber Ei ns ei n, Sophi aan i pol i s, Fr ance Tempor ar yfel l ow, I ns i u eofadvanceds udi es( I AS), Dur ham Uni ver s i y( UK)and Honor ar ypr of es s ora hekor euni ver s i yofenna( I al y) & Andr easpykauni ver s i yofhohenhei m, Economi csi ns i u e, Wol l gr as weg23, D70599 S u gar, Ger many, EMai l : a. pyka@uni hohenhei m. de * Cor r es pondi ngau hor

2 FROM NECESSITIES TO IMAGINARY WORLDS: STRUCTURAL CHANGE, PRODUCT QUALITY AND ECONOMIC DEVELOPMENT *Pier Paolo Savioi, INRA- GAEL, Universié Pierre Mendès- France, BP 47, Grenoble, France E- mail: pier- GREDEG CNRS, 250 Rue Alber Einsein, Sophia Anipolis, France Temporary Fellow, Insiue of Advanced Sudies (IAS), Durham Universiy (UK) and Honorary Professor a he Kore Universiy of Enna (Ialy) & Andreas Pyka Universiy of Hohenheim, Economics Insiue, Wollgrasweg 23, D Sugar, Germany, E- Mail: a.pyka@uni- hohenheim.de *Corresponding auhor This paper has been originally published in Technological Forecasing & Social Change, Vol. 80 (2013) , and is hereby reproduced in a working paper forma according o a License Agreemen beween Pier Paolo Savioi and Elsevier A documenaion for he TEVECON model used in his paper is available in Research Gae: hps:// DOI: /RG Key words: Innovaion, srucural change, economic developmen, disposable income, populaion Absrac In his paper we explore how innovaion and srucural change affeced economic developmen in he long run, by which we mean a period such as he one beween he indusrial revoluion and he presen. We separae he period since he indusrial revoluion ino wo sub periods, which we call necessiies and imaginary worlds and focus on hree rajecories, increasing producive efficiency, increasing oupu variey, and increasing oupu qualiy and differeniaion. In he paper we show how a combinaion of he hree rajecories gave rise o he ransiion beween necessiies and imaginary worlds and propose a mechanism of economic developmen which could have given rise o he ype of economic sysem which we can observe oday. To creae growing oupu qualiy and differeniaion higher compeencies were required. These higher compeencies required higher levels of educaion and demanded higher wages, which conribued o raise consumers' purchasing power. These phenomena, combined wih he income effec of he creaion of new secors, generaed he disposable income wih which consumers could purchase he new, higher qualiy, non necessiies, goods and services generaed by innovaion. In he paper we sudy he impac of several model parameers on he sabiliy of he viruous circle previously described. 1

3 1. INTRODUCTION The main objecive of his paper is o compare he roles of oupu variey and of produc qualiy in economic developmen. In paricular, we wish o explain why produc qualiy sared increasing only a considerable ime afer he beginning of he indusrial revoluion and was preceded by an economic developmen driven almos exclusively by secoral differeniaion. Thus, we separae he period since he indusrial revoluion ino wo sub periods, which we call necessiies and imaginary worlds. In he firs period mos people could afford only necessiies while in he second one a growing percenage of he populaion of indusrialized counries sared o be able o afford goods and services which were no necessiies, bu wha some auhors have called higher goods services (Menger, 1950). In his paper we use he concep of rajecory and focus on hree rajecories, increasing producive efficiency, increasing oupu variey, and increasing oupu qualiy which includes also produc differeniaion. Amongs he variables which we expec o have he greaes impac on oupu variey and on produc qualiy we have seleced wages, raes of populaion growh and educaion. In he paper we will use a model of economic developmen by he creaion of new secors, called TEVECON, which we have previously creaed. In he paper we will describe TEVECON in greaer deail, bu some of is feaures deserve o be anicipaed here. Thus, innovaion and srucural change play a cenral role in i. Furhermore, TEVECON is inended o be a long run model of economic developmen, an objecive which is here inerpreed as poenially focusing on he period saring from he beginning of he indusrial revoluion. TEVECON is a sysemic model, in which he ineracions beween he componens of he model are of crucial imporance. For example, search aciviies and demand co- evolve. A disincive feaure of our approach is ha we ake ino accoun boh demand and supply facors by sudying he co- evoluion of demand and innovaion. 2. CONCEPTUAL BACKGROUND 2.1. STRUCTURAL CHANGE We can sar our sudy wih he observaion ha a very large number of new secors has been creaed since he indusrial revoluion. Examples of hese secors are hose producing cars, aircraf, compuers, radios, elevision, refrigeraors, plasics ec. The emergence of hese and of oher secors needs o be explained. No heory or model of economic developmen can escape he quesion: How and why did hese secors emerge? Given ha he composiion of he economic sysem changed and ha his change in composiion is a clear example of srucural change, he cenral quesion o be raised here is wheher srucural change is involved in economic developmen and, if so, how. 2

4 Furhermore, given ha srucural change and growh are relaed bu no idenical, he relaed quesion of wheher srucural change conribues o growh arises. Srucural change is a much broader phenomenon for which many definiions are possible (Silva, Teixeira, 2008). In principle he srucure of a sysem is consiued by is componens and by heir ineracions. Componens can be defined a several levels of aggregaion varying from individuals o organizaions and indusrial secors. In pas lieraure on he subjec srucural change has been mos ofen sudied as he changing weigh of secors defined a levels of aggregaion varying from primary, manufacuring and services o he differen subsecors of each of he previous hree (see for example Baumol, 1967; Chenery,1960; Kuznes, 1967; Cornwall; 1977, Saler, 1966; Fabrican, 1940, Pasinei, 1981, 1993; Fagerberg, 2000: Verspagen 1993; Mecalfe, Foser, Ramlogan 2005). The ype of srucural change in which we are ineresed occurs a a level of aggregaion lower han he riparie represenaion based on agriculure, manufacuring and services. In his as in our previous papers we are ineresed in he mechanisms which drive he creaion and he subsequen evoluion of secors and in he iner- secor ineracions which give rise o he emergence of new secors. Thus, we focus boh on he emergence of new secors and on he changing share of oupu and of employmen which occurs during heir subsequen evoluion. Our secors do no provide a specific represenaion of he feaures of hose of a real economic sysem bu include elemens of secoral dynamics which can be considered common o mos secors. The definiion of secors we use is compaible wih hem being eiher manufacuring or services. The only secor which is differen from all he oher ones is he firs secor, which we consider he one producing necessiies. The quesion which hen arises is wheher srucural change is a deerminan or jus a consequence of growh. Our saring poin will be he observaion ha economic developmen has been very uneven (refs above). Observed raes of growh differed markedly for differen secors a a given ime and for he same secor in he course of ime. Furhermore, he iming of he emergence of new secors differed amongs counries or economic sysems depending on heir levels of economic developmen. To pursue our analysis we sar by comparing he wo conceps of proporional and non- proporional growh (see Pasinei, 1981, Chenery, 1960). Proporional growh occurs when all secors have he same rae of growh of produciviy and of demand and when he rae of growh of produciviy equals he rae of growh of demand wihin each secor. In his siuaion he composiion of he economic sysem, as represened by he oupu and employmen share of differen secors, would remain consan in he course of ime. In oher words, if proporional growh occurred here would be no srucural change. We siuae our paper wihin evoluionary economics. In his sense TEVECON has a number of similariies wih recen evoluionary models such as hose by Dosi e al (2010) or by Ciarli e al (2010, 3

5 2012). While we share some basic assumpions wih hese models, such as he absence of opimizaion or of general equilibrium, our model has some specificiies. Our emphasis on srucural change is shared by Ciarli e al bu no by Dosi e al. On he oher hand Ciarli e al placed greaer sress on he behavioural foundaions of heir model. However, TEVECON's emphasis on he endogenous change in composiion of he economic sysem, and in paricular he endency owards a growing differeniaion, or on he balance beween growing oupu variey and growing secoral qualiy and differeniaion, are srong TEVECON specificiies. If compared wih he res of he lieraure TEVECON is an endogenous growh model boh in he sense ha one of he main facors leading o growh is consiued by search aciviies, a general analogue of R&D (Nelson, Winer, 1982) ha hese search aciviies use resources creaed in he process of economic developmen and in he above menioned sense ha he composiion of he economic sysem endogenously changes. Wih some endogenous growh models i shares he neo- Schumpeerian inspiraion in he roles of enrepreneurs and of compeiion. However, wih respec o endogenous growh models TEVECON differs for a) combining oupu variey and secoral oupu qualiy and differeniaion while Romer (1990) or Aghion and Howi (1992) use only one of hese. Grossman and Helpman (1991) place a considerable emphasis on produc qualiy, bu do no combine i wih he creaion of new secors. Furhermore, and even more imporanly, while mos endogenous growh models are exclusively supply based TEVECON models he co- evoluion of innovaion and demand. Anoher srand of lieraure wih which TEVECON in general and his paper in paricular has some similariies is he so called unified growh heory (Galor, Weil, 2000; Galor, 2005). Here he similariy consiss of he emphasis on he long run, alhough unified growh heory aims for a much longer ime horizon exending back o he beginning of human hisory. As already poined ou, our inended ime horizon is he period since he indusrial revoluion o he presen, which would be he hird period of unified growh heory. Thus, while aiming for he long run our run is less long. However, we hink he endogenously generaed srucural change in TEVECON is a mechanism which eiher did no exis or played a negligible role before he indusrial revoluion. Thus, i would no be possible o exend TEVECON back in ime wihou inroducing addiional mechanisms. In he emphasis we place on srucural change we rely no only on evoluionary economics bu on a number of conribuions from differen research radiions ranging from srucuraliss, such as Chenery (1960) or Kuznes (1957), o he Cambridge (UK) school of economics (Pasinei, 1981,1993) and o he work of enlighened neo- classical economiss (Baumol, 1967, Acemoglu, Ziliboi, 1997). Furhermore, as i will be seen laer, we no only sress srucural change bu he direcion i akes. 4

6 Our model predics ha under a wide range of circumsances economic developmen will give rise o a growing differeniaion of he economic sysem, or, in oher words, o a growing oupu variey. When we sared developing our model his poin of view was no uniformly acceped bu a growing number of recen papers seem o provide increasing confirmaion for he growing differeniaion of he economic sysem (Acemoglu, Zliboi, 1997; Funke, Ruwhedel, 2012a, 2001b; Imbs Warcziag, 2003; Pareka, Tamberi 2008, De Benedicis e al 2009; Frenken e al, 2007; Savioi, Frenken 2008; Savioi, Nesa, Javaid, 2010). We conclude his secion by noing ha he combinaion of research radiions we cie and use does no qualify as a form of pachwork bu ha i follows from he convicion ha economic heory does no need o be permanenly fragmened, bu ha inclusion of differen and usually no easily combinable sources can lead o more broad ranging and synheic models capable of explaining more complex siuaions han i was possible in he pas TRAJECTORIES AND PATTERNS OF ECONOMIC DEVELOPMENT Models of economic developmen need o be able o explain paerns of long run developmen and growh. Here long run is inended o indicae a period such as he one from he indusrial revoluion o he presen. Focusing on such a period requires undersanding he broad feaures which occurred in i. Firs, we had he emergence of manufacuring indusry. Second, wihin manufacuring iself here was a progressive differeniaion, beginning wih secors such as exiles, energy (seam engine), railways, seel and following wih chemicals, elecriciy, cars, planes ec. During his process manufacuring indusry became increasingly differeniaed, wih newer secors coexising wih older ones. Third, he employmen share of services overook ha of manufacuring. Any model of economic developmen which is in principle capable of inerpreing evens which occurred since he indusrial revoluion needs o explain why such srucural change occurred. The fundamenal ingredien which gives rise o growh and developmen in our work is innovaion. The emergence of innovaions is due o search aciviies, which provide he knowledge required o creae and modify innovaions. Innovaions affec economic developmen because enrepreneurs found new firms o exploi he oucomes of search aciviies and because consumers and users purchase he producs and services embodying such innovaions. In his process he economic sysem becomes increasingly differeniaed. The addiion of new secors o he economic sysem no only conribues o srucural change bu o a srucural change occurring in a paricular direcion, ha of increasing differeniaion. 5

7 The above processes can be described in erms of hree rajecories and of wo periods. The concep of rajecory is amongs he mos imporan in evoluionary economics (Nelson, Winer, 1977; Dosi, 1982). However, i is generally used o indicae rajecories occurring wihin paricular echnological paradigms or echnological regimes. The rajecories we refer o here are much longer lasing and hey occur a higher levels of aggregaion. Typically such rajecories can occur for naional economies bu hey are common o whole economic sysems, alhough he speed a which various counries proceed along hem can vary considerably. They are no specific o any paricular echnology, alhough new echnologies are likely o emerge because hey allow a faser movemen along hese rajecories. Trajecory 1. The efficiency of producive processes increases during he course of economic developmen. Here efficiency mus be undersood as he raio of he inpus used o he oupu produced, when he ype of oupu remains consan. Trajecory 2. The oupu variey of he economic sysem increases in he course of ime. Here such variey is measured by he number of disinguishable secors, where a secor is defined as he se of firms producing a common alhough highly differeniaed oupu. Trajecory 3. The oupu qualiy and inernal differeniaion of exising secors increases in he course of ime afer heir creaion. This means ha if during he period of observaion he ype of oupu changes wha we will observe is a combinaion of growing producive efficiency and of qualiy change. From now on we will use he erm variey as a synonymous of diversiy, alhough he wo are in principle no idenical. Such variey can exis a he iner- as well as a he inra- secoral level. Thus, wo secors will produce compleely differen ypes of oupu while one secor will produce a diversified oupu. In he lieraure hese wo ypes are ofen described as verical and horizonal differeniaion respecively. Such long run rajecories do no emerge separaely bu exis due o a complex paern of ineracions wihin he economic sysem. We can recall here ha he lieraure on differeniaion cied above provides growing evidence for he exisence of rajecory 2. Growing producive efficiency is he oldes and, unil he indusrial revoluion, he mos developed of he hree rajecories. For example, he efficiency of food producion increased wih he ransiion from huners gaherers o seled agriculure (Diamond,1997). However, any such increases in producive efficiency were very slow and no necessarily cumulaive. Producive efficiency sared growing in a cumulaive fashion only afer he beginning of he indusrial revoluion (Maddison, 2001). Simple recen examples of his rajecory can be found in he falling number of workers 6

8 required o produce a uni of oupu in he seel, chemicals or car indusries. Of course, hese are jus examples and he phenomenon is far more general. Growing producive efficiency is cerainly one of he facors which conribued o economic growh since he indusrial revoluion. However, he observed paerns of economic developmen could no have been produced by growing producive efficiency alone. If his had been he case we would oday be producing Ford Model T like cars wih much smaller quaniies of all he inpus required. As even he mos casual observer would have noiced, oday's cars are no only produced much more efficienly han hose of he early XXh cenury bu hey are also of a much higher qualiy. Hence, growing producive efficiency and growing oupu qualiy were combined in he paerns of economic developmen which we can observe oday. During he indusrial revoluion oupu differeniaion (rajecory 2) was very limied. A he beginning i occurred mosly a he level of capial goods (new exile and engineering equipmen, railways equipmen ec) and only considerably laer a he level of consumer goods. The increasing inernal differeniaion and oupu qualiy of consumer goods and durables sared increasing during he XIXh cenury and in paricular afer he beginning of he XXh cenury. Growing oupu variey can be observed a he iner- secor level. A clear example of his is he large number of compleely new secors which emerged during he XXh cenury, such as cars, aircraf, elevision, compuers, elecommunicaions ec. All of hese no only consiued compleely new secors bu underwen a very high degree of inernal differeniaion. These hree rajecories are no independen. None of hem could have occurred alone wihou he oher wo. Thus, a coninuous increase in producive efficiency, if no accompanied by he emergence of new secors and by heir inernal differeniaion and rising qualiy could have led he economic sysem o a boleneck in which all demanded oupu could have been produced by a declining proporion of he labor force. Such a boleneck, deermined by he imbalance beween coninuously increasing producive efficiency and sauraing demand, could have been overcome by he emergence of new secors (Pasinei, 1981). While he assumpion of demand sauraion and he neglec of he inernal differeniaion of secors limied he possible generalizaion of Pasinei's approach, we have shown ha boh he emergence of new secors and heir increasing qualiy and inernal differeniaion provided addiional scope for furher growh and allowed is coninuaion in he long run. In his conex, full demand sauraion is unlikely o occur wihin any secor as long as new secors keep being creaed (Savioi, Pyka, 2009). Furhermore, boh he emergence of new secors and heir growing qualiy and inernal differeniaion can compensae for he diminishing capabiliy of incumben and mauring secors o creae employmen. 7

9 In previous documens we described he period from he indusrial revoluion o he presen as he ransiion from necessiies o imaginary worlds. This descripion emphasizes ha unil he end of he XIXh cenury mos people, even in counries which were for he sandards of he ime relaively rich, could no purchase anyhing bu bare necessiies. All hroughou he XIXh cenury Briish working class households spen abou niney percen of heir income on food, clohing and housing. Only during he XXh cenury, and in paricular afer he 1930s, he share of income spen on he above hree caegories sared falling (Hobsbawm, 1968, diagrams 45 and 46). By he 1950s he share of necessiies fell o abou sixy percen, leaving abou fory percen o be spen on oher, presumably higher, goods and services. The compression of he combined expendiure on necessiies, which could be generaed by he combined effec of rajecory 1 and by he employmen in he producion of non- necessiies, creaed he disposable income required o buy he new goods and services which were gradually being creaed. Saring from he beginning of he XXh cenury new goods and services emerged (rajecory 2) and heir qualiy and differeniaion increased consanly (rajecory 3). This combinaion of rajecories conribued o a mechanism which allowed he capialis economic sysem o creae growing wealh for mos of he populaion of indusrialized counries. 3. TEVECON: A MODEL OF ECONOMIC DEVELOPMENT BY THE CREATION OF NEW SECTORS Our model of economic developmen by he creaion of new secors (acronym: TEVECON) has been developed over he las decade and has already undergone a number of modificaions and exensions (see Savioi and Pyka 2004a, 2004b, 2004c, 2008a, 2008b, 2009, 2010). A deailed formal descripion of he model is beyond he scope of his paper. Therefore, we refer o he appendix which conains he mos imporan equaions and a lis of variables. Here we resric ourselves o a narraive descripion of he basic mechanisms. This version of TEVECON is conceived o bring ogeher he hree rajecories oulined above: Each secor is generaed by an imporan innovaion which offers scope for efficiency increases describing rajecory 1. The sequence of he emergence of new secors corresponds o rajecory 2. Qualiy improvemens wihin each secor as well as inernal differeniaion give rise o rajecory THE SECTORAL LEVEL: SUPPLY SIDE The core of he model is he evoluion of an indusry from he emergence phase o is mauriy: he life of a new indusry begins when an innovaion creaes a poenial marke and gives rise o wha we call an adjusmen gap. The erm adjusmen gap is due o he fac ha, as soon as a poenial marke is creaed, i is in fac empy: neiher he producive capaciy nor he demand for he innovaion is presen. They are gradually consruced during he life cycle of he new secor. As he secor maures, he adjusmen gap is coninuously closed: a producive capaciy, which in he end 8

10 maches demand, is creaed. When his happens, he secor eners is sauraion phase. The producive capaciy is generaed by Schumpeerian enrepreneurs (Schumpeer 1912) esablishing new firms iniially induced by he expecaion of a emporary monopoly and of he relaed exraordinary profis. The success of he innovaion gives rise o a band wagon of imiaors shaping rajecories 1 and 3. The number of firms in he new secor gradually rises, bu his also raises he inensiy of compeiion in he secor, hus gradually reducing he inducemen o furher enry. Afer he inensiy of compeiion in he new secor reaches levels comparable o hose of esablished secors, he new secor is no longer innovaing bu becomes par of he circular flow. When a secor achieves mauriy in he way described above, an inducemen exiss for Schumpeerian enrepreneurs o se up a new niche, which can evenually give rise o he emergence of a new indusry. This way he model generaes a sequence of indusry life cycles of poenially co- exising indusries, i.e. an increasing variey (rajecory 2). In order o illusrae qualiaively he developmens generaed by our model, figure 1 shows he developmen of he number of firms in a cerain indusry. Wihin a wide range of condiions, he number of firms in each secor grows iniially, reaches a maximum and hen falls o a fairly low value. Wihin hese condiions, each secor seems o follow an indusry life cycle (e.g. Klepper 1996). In our case, he cyclical behaviour is caused by he combined dynamics of innovaion, compeiion and demand number of firms Fig 1. Number of firms A prominen role in his process is played by search aciviies, a general analogue of R&D. Search aciviies are defined as all he aciviies which can provide he basis for he emergence of new rouines. Thus, search aciviies are he source of innovaions and depend on he accumulaed secoral demand observed by he firms in an indusry as an indicaor of marke opporuniies. The secoral search aciviies posiively affec produc differeniaion and qualiy improvemens and also labour produciviy by increasing he oupu of he firms in an indusry. 9

11 The wages in a secor direcly follow he developmen of labour produciviy and end o increase wih mauraion. The improvemens in produciviy are furher posiively influenced by he creaion of secor specific human capial which depends on he relaive share of invesmen in educaion, physical capial and search aciviies in he secor. Wages are furhermore an imporan cos componen which deermines produc prices in a mark- up pricing process. The developmen of prices of course influences he secoral demand. 3.2 THE SECTORAL LEVEL: DEMAND SIDE Exising models of growh are mosly supply based and pay no aenion o demand. However, innovaion would no have had any impac on economic developmen if he producs embodying specific innovaions had no been purchased. Two condiions are required for his: (i) consumers mus have a disposable income which allows hem o purchase he new goods and services and (ii) consumers mus have or develop preferences which make hem value posiively he innovaion. As disposable income we undersand he residual income lef over in a given period, afer all he ypes of consumpion of previous periods have been saisfied. For he preferences of consumers we simply disinguish beween conservaive or progressive preferences owards novelies. The demand funcion depends negaively on price, posiively on oupu qualiy and differeniaion, on he presence of a disposable income and of appropriae preferences. Tha demand and innovaion co- evolve can be undersood by considering ha produc differeniaion, qualiy improvemens and prices are affeced by search aciviies while in urn search aciviies depend on he accumulaed demand. Thus, demand affecs innovaion hrough secoral search aciviies and innovaion affecs demand by means of produc price, produc qualiy and differeniaion. This imporan co- evoluionary loop is analysed in deail in Savioi and Pyka (2012). In TEVECON he allocaion of demand o differen secors is no based on maximizaion of uiliy by consumers, bu on he combinaion of preferences and of disposable income followed by oupu qualiy, differeniaion and price. The disposable income is creaed for each secor based on he growing producive efficiency of incumben secors and on he income creaing effec of invesmen in new secors. Thus, demand allocaed o new secors is parly based on he need o keep older secors going which requires he co- exisence of indusries emerged a differen periods. 3.3 THE MACROECONOMIC LEVEL In our model, he variey of he economic sysem plays an essenial role. Economic variey is approximaed by he number of differen secors exising simulaneously (rajecory 2). By he creaion of new secors he economic sysem provides he mechanism whereby economic 10

12 developmen can coninue in he long run. This way, he economic sysem can escape he rap generaed by he imbalance beween rising produciviy and sauraing demand, which consiues a boleneck in a sysem a consan composiion. The macroeconomic dimension in TEVECON is given by he co- exisence of differen indusries in differen phases in he life cycles. In order o observe he macroeconomic developmens we aggregae secoral figures e.g. for employmen and income. This allows for he idenificaion of macroeconomic rends which sem from secoral developmens which migh move in opposie direcions. An example is given by he macroeconomic employmen siuaion: In Savioi and Pyka (2004b) we find ha under paricular circumsances our arificial economic sysem can keep generaing employmen, even when employmen creaion is falling wihin single secors. Fig. 2 shows he course of developmen of employmen in single indusries - which firs srongly increases, bu in he shake- ou period also is reduced considerably due o raionalizaion and economies of scale and he rend of he aggregae employmen on he macroeconomic level, which neverheless can be posiive. Fig. 3 displays he overall income developmen in our economic sysem calculaed from he secoral producion figures and secoral prices. Figures 2 and 3 illusrae a decisive advanage of our approach of numerically modelling indusry evoluion: By aggregaing he various figures we can no only observe he secoral developmens bu also he macroeconomic figures, hereby deecing overall beneficial or disadvanageous developmens. In paricular, he macroeconomic growh pah depends no only on he employmen dynamics of individual secors bu also on he delay beween he emergence of any wo secors, a magniude ha we call iner- secor delay: he larger he iner- secor delay, he slower he macroeconomic rae of growh (Savioi, Pyka, 2008b) secoral employmen and linear rend of aggregae employmen Fig. 2) Secoral and aggregae employmen curves 11

13 income developmen Fig 3. Evoluion of macroeconomic income 4. FROM NECESSITIES TO IMAGINARY WORLDS AND FROM LOW TO HIGH QUALITY In order o sudy he ransiion beween necessiies and imaginary worlds we consider ha secor N 1 in TEVECON is producing necessiies and we call necessiies food. We assume ha here would be a minimum amoun of food required for human survival. The populaion of our economic sysem is expeced o increase or o fall depending on wheher food producion is greaer han or lower han he survival quaniy (Eq 1). k 0 pop Q FoMin Food Pop = Pop 1 (1) 0 ED QFoMin where: Pop := populaion a ime ; Q FoMin := minimum quaniy of food required for survival; Food := food producion a ime k pop: = a parameer which deermines he effec of food producion on he rae of populaion growh ED 0 := invesmen in educaion a ime zero In he following par of he paper ED 0 will be given differen values or i will be made variable depending on he qualiy level of he oupu. In our previous papers invesmen was disribued amongs educaion, search aciviies and physical capial bu his disribuion was kep consan during each experimen. The disribuion of invesmen could be varied in differen experimens. In his paper we will parly endogenize his disribuion by making i dependen on he qualiy level of he oupu. We can expec higher oupu qualiy o require higher levels of educaion in he labor force. In his case equaion ED Q will ake he following form (Eq 2): 12

14 ED Q = ED 0 + k Qual Y (2) where ED Q := invesmen in educaion a ime depending on oupu qualiy level a he same ime Y = oupu qualiy k qual := parameer deermining he increase in educaion invesmen required o increase oupu qualiy To sudy his problem he simulaion experimens deal wih a deerminisic case where we change single parameer values for differen experimens. In order o cover a ime horizon which spans a ime period of approximaely one cenury we have chosen 2000 ieraions for each simulaion run. This number of ieraions is no o be equaed wih real ime seps bu sufficien o qualiaively discover he decisive mechanisms and effecs. The same consideraions have deermined our choice for he value of parameers of he sandard scenario which are no empirically calibraed bu properly chosen o generae a long run pah of economic developmen driven by he emergence of new indusries (Savioi and Pyka 2004a). In oher words, we sar from a siuaion in which new secors are regularly creaed and where he aggregae raes of growh of employmen and of oucome are posiive. We call his se of parameers our sandard scenario. To summarize, he value of our model has o be judged by is capaciy o reproduce observed rends and paerns raher han precise values of precise values of measurable properies of he economic sysem. To do ha we need o allow for a long enough ime horizon. The chosen se of parameers allows for robusness of qualiaive resuls wihin a broad range of he parameers (Savioi and Pyka 2004b). As we largely absain from he recourse o sochasic effecs and consider equal iniial condiions for all secors he experimens can be perfecly repeaed and do no require Mone- Carlo ess. We can in principle expec differen combinaions of he emergence of new secors (rajecory 2) and of he growing qualiy and differeniaion of goods and services (rajecory 3) o give rise o differen developmen pahs. To explore he relaive impac of hese wo rajecories we simulae wo developmen scenarios, called high qualiy (HQ) and low qualiy (LQ) respecively. These scenarios were obained by giving differen values o he parameers k 7 - k 10 of equaions (A9) and (A10) in he appendix. These parameers deermine he exen of produc qualiy and differeniaion corresponding o a given level of search aciviies. The LQ scenario is obained by giving he parameers k 7 o k 10 values so low ha produc qualiy and differeniaion are very low and almos consan during he ILC of he secor. The HQ scenario is obained by giving he same parameers considerably higher values. The resuls of his simulaion show ha he HQ and LQ scenarios give rise 13

15 o very differen developmen pahs. The comparison HQ- LQ is explored by means of boh micro- and macroeconomic variables. Fig 4. Effec of produc qualiy on aggregae income Y. The verical line indicaes he ime required for HQ income o cach up wih and o overake LQ income, which we call ICUT Fig. 5. Effec of produc qualiy on he aggregae employmen. Ligh curve LQ, hick curve HQ A an aggregae level: The rae of creaion of new secors is higher in he low qualiy case compared o he high qualiy case. 14

16 The rae of income growh (RIG) of he HQ scenario is iniially lower bu i overakes ha for he LQ scenario a a laer ime (fig 4). We can also noice ha RIG slows down in he course of economic developmen for he LQ scenario while i acceleraes for he HQ scenario. Employmen growh is always faser in he low qualiy case wih respec o he high qualiy case (fig 5). In he LQ scenario demand, human capial, wages and oupu remain subsanially saic or even declining while hey increase in he HQ scenario. The curves in figures 6 o 9 display he developmen on a secoral level and show only he curves of he second secor for he LQ and HQ scenarios. In he LQ scenario demand, human capial, wages and oupu would remain subsanially saic or even decline while hey would increase in he HQ scenario. Fig 6. Effec of produc qualiy on secoral demand. Ligh curve LQ, hick curve HQ Fig. 7. Effec of produc qualiy on he qualiy of human capial. Ligh curve LQ, hick curve HQ 15

17 Fig 8. Effec of produc qualiy on secoral wages. Ligh curve for LQ, hick curve for HQ Fig 9. Effec of produc qualiy on secoral oupu. Ligh curve for LQ, hick curve for HQ The sriking differences in he economic developmen pahs of he LQ and HQ scenarios shown in Figs 4 and 5 can be undersood by examining he behavior of he economic sysem a he secoral level. Figs 6-9 show how in he LQ scenario produc qualiy, secoral demand, oupu, he qualiy of human capial and wages remain almos consan or slighly decline while in he HQ scenario all hese variables increase subsanially in he course of ime. The higher rae of employmen growh (REG) of he LQ scenario is hen obained by keeping wages, human capial, demand and oupu qualiy consan. On he oher hand, in he HQ scenario a lower REG is parly compensaed by higher wages, human capial and oupu qualiy. Thus, he HQ scenario would creae a smaller bu more compeen, beer paid and enjoying a higher level of consumpion labor force (see able 1). 16

18 LQ HQ Oupu ~Consan Growing Demand ~Consan Growing Oupu qualiy ~Consan Growing Human capial ~Consan Growing Wages ~Consan Growing Rae of employmen growh Higher han HQ Lower han LQ Rae of income growh Iniially higher & hen lower han HQ Iniially lower & hen higher han LQ Table 1. Comparison of he Low Qualiy (LQ) and High Qualiy (HQ) scenarios The self- acceleraing and self- limiing shapes of he rae of income growh (RIG) curves for HQ and LQ scenarios can be undersood because in he former case an increase in demand leads o an increase in search aciviies, which in urn leads o an increase in oupu qualiy and differeniaion, which is finally ranslaed ino an increase in demand. This feedback loop is considerably weakened in he LQ scenario because in his case search aciviies have a negligible impac on oupu qualiy and differeniaion. The observed economic developmen in which for mos counries consumpion focused exclusively on necessiies for mos of he XIXh cenury and sared including oher ypes of consumpion only during he XXh cenury resembles a combinaion of he LQ and HQ scenarios. This combinaion corresponds o a ransiion from he former o he laer, occurring as he income generaed by he HQ scenario, iniially inferior, overakes ha of he LQ scenario (Fig. 4). We do no hink ha his mechanism provides a complee explanaion of he ransiion from necessiies o imaginary worlds. Anoher variable which could have led o he sagnaion of purchasing power and consumpion is he rae of populaion growh. According o economic hisorians (Mokyr, 1990; Maddison, 2001, Galor, Weil 2000; Galor 2005) he high rae of populaion growh during he early years of he indusrial revoluion is likely o have swamped he per capia changes which he revoluion iself could have generaed, hus poenially affecing he LQ- HQ ransiion. In order o undersand how he rae of populaion growh ineraced wih he hree rajecories of increasing efficiency, variey and qualiy we now explore he impac of populaion, wages and educaion on economic developmen. For his purpose we calculae populaion, employmen and unemploymen. In paricular we are ineresed in comparing unemploymen in he LQ and HQ scenarios and in sudying he effec of changing some TEVECON parameers. 17

19 Fig 10. Populaion (black curve) and employmen (grey curve) in he sandard scenario Fig 11. Unemploymen in he sandard scenario In our sandard scenario unemploymen is high in he early phases bu hen falls gradually even o he poin of becoming a labour shorage (fig. 11). The reason for such behaviour is clearly shown in fig. 10 where populaion and employmen are represened, given ha unemploymen is he difference beween he wo. Unemploymen growh predominaes when populaion growh is greaer han employmen and falls or becomes a labour shorage when populaion growh becomes equal o or is smaller han employmen. These resuls show ha he rae of populaion growh (RPG) can considerably affec he observed economic developmen pah. In a nex sep we explore he influence of educaion on economic developmen by varying he corresponding iniial invesmen. Fig 12. Effec of in invesmen in educaion on populaion growh. Iniial invesmen increases from dark o ligh. 18

20 Populaion growh is srongly affeced by modificaions in he disribuion of invesmen aciviies. As expeced from our populaion equaion (1), a lower invesmen in educaion has a posiive impac on populaion growh. This resul corresponds nicely o he observed evoluion of several economic sysems: as educaion levels rise, raes of populaion growh fall. In real economic sysems his phenomenon is due a complex se of ineracions including he combinaion of he lower need for children, who are parly subsiued by social assisance, and of he higher cos of educaing hem adequaely. For he momen TEVECON does no include all hese componens and ineracions. If ha occurred wihin cerain limis we could expec a higher invesmen in educaion o lower he unemploymen rae and o raise consumers' income. Tha his occurs is shown in figs. 13 and 14 which represen he influence of invesmen in educaion on income per capia and on unemploymen. We can also undersand ha if he HQ scenario provided a higher income han he LQ scenario bu a he expense of lower employmen, increasing invesmen in educaion can lead o boh higher income and higher employmen, hus parly compensaing he employmen disadvanage of he HQ scenario. This seems o correspond nicely o observaions indicaing ha in knowledge based socieies growh and employmen are closely linked o invesmen in educaion. Fig. 13. Income per head for various levels of iniial invesmen in educaion. Iniial invesmen increases from dark o ligh. Fig. 14. Unemploymen for various levels of iniial invesmen in educaion. Iniial invesmen increases from dark o ligh. 19

21 Anoher variable which can be expeced o affec he balance beween employmen and income is wages. We explore he influence of his variable by varying k w in Eq (A2) in he appendix, a parameer ha affecs wages by raising or lowering hem a equivalen labour produciviy. In he following experimen k w is given he values {0.1; 0.5; 1.0; 1.5; 2.0; 2.5; 3.0} wih 1.0 corresponding o he sandard scenario (Figs 15-16). Fig 15. Income per head in he HQ scenario for differen values of k w. Income per head rises wih rising values of k w from ligh o dark. Fig 16 a, b. Impac of k w on employmen (a, lef) and on unemploymen (b, righ). Values of kw rise from ligh o dark. Rising wages deermined by growing values of k w lead o higher Income per head (fig. 15). The differenial effec of k w increases afer abou one housand periods giving rise o a growing divergence in income per head. On he oher hand, higher values of k w lead o lower raes of employmen growh (fig. 16a) and o higher raes of unemploymen growh (fig. 16b). I seems as if here is a rade- off beween revenues and employmen: higher wages raise revenues bu a he expense of lower employmen and higher unemploymen. Even for employmen and unemploymen raes he effec of k w becomes considerably more marked afer he firs one housand periods. The LQ scenario seems o be much less affeced by variaions in wages han he HQ scenario. As a consequence we do no reproduce he corresponding resuls here. This difference can be explained by he fac ha wages, oupu qualiy, demand and human capial remain almos consan in he LQ 20

22 scenario and we can expec hem o be much less affeced by variaions in k w han in he HQ scenario. The previous resuls can be a leas parly explained by he following mechanism (fig. 17): The producion of oupus of higher qualiy and differeniaion requires increasingly sophisicaed compeencies in he labor force Such more sophisicaed compeencies require a greaer inpu from educaion and raining sysem In urn, such more sophisicaed compeencies need o be paid higher wages These higher wages plus hose paid o he people eaching and raining provide he disposable income required for consumers o be able o afford oupus of higher qualiy and differeniaion The combined influences of hese variables and of heir ineracions reinforce one anoher and lead o a self- susaining mechanism coninuously generaing higher oupu qualiy, higher wages and higher income. Such a mechanism is likely o have been an imporan componen of he process of economic developmen of advanced capialis counries during he XXh cenury. Fig. 17: Co- evoluionary mechanism parly explaining he adven of oupus of higher qualiy and differeniaion in he process of capialis economic developmen. 21

23 The mechanism represened in fig 17 is essenially a co- evoluionary one based on he ineracion and on he posiive feedback of a number of variables. Alhough such mechanism is likely o have played an imporan role in economic developmen, i is a possible bu no an ineviable one. The ypes of ineracions and feedback leading o economic developmen do no exis under all circumsances and in all economic sysems. The following experimen gives an example of a se of condiions under which he above mechanism would no be conducive o economic developmen. In equaion (2) he parameer k Qual measures he invesmen in educaion required o produce a given rise in oupu qualiy. The higher he value of k Qual he more cosly i will be o raise oupu qualiy by a given incremen. The resuls of his experimen in which k Qual is varied below and above he value corresponding o he sandard scenario are shown in figs. 18 and 19. In hese figures we can see ha unemploymen rises and income per capia falls as k Qual increases. The resuls of his experimen can be inerpreed by considering ha higher values of k Qual correspond o higher coss of producing given levels of oupu qualiy. We can expec ha here will be a cos of raising oupu qualiy beyond which he economic oucome would no be sufficien o jusify he invesmen in educaion. In oher words, his shows ha here are diminishing reurns o invesmen incurred in raising oupu qualiy and ha he viruous circle in which compeencies, human capial, wages, purchasing power, ec increase in concer and allowing for coninued growh does no exis under all circumsances. Fig. 18. Effec of increasing k Qual on he rae of growh of unemploymen. Higher values of k Qual correspond o ligher curves. 22

24 Fig. 19. Effec of increasing k Qual on income per head 5. SUMMARY AND CONCLUSIONS The main problem we have been focusing on in his paper is he relaively lae onse of a paern of consumpion which differeniaed away from necessiies o include many producs and services which eiher were no available and/or could no have been judged necessiies. The problem is no so much ha his ype of differeniaion occurred bu ha i did no sar occurring earlier in spie of he considerable improvemen in producion efficiency which began wih he indusrial revoluion. An explanaion which was previously given for he above phenomenon relied on he high rae of populaion growh accompanying he firs par of he indusrial revoluion. The early gains in producive efficiency would hen have been used up o feed a growing populaion raher han o expand individual consumpion. Alhough we find ha populaion growh did play a role in he sense indicaed, our paper shows ha oher mechanisms were a work o deermine he observed economic developmen pah. In his paper we mainain ha economic developmen could no have been based exclusively on he producive efficiency bu i needed o rely on he join co- evoluionary effecs of hree rajecories (i) increasing producive efficiency, (ii) increasing variey and (iii) increasing secoral oupu qualiy and differeniaion. We showed ha differen combinaions of increasing variey and of increasing secoral oupu qualiy and differeniaion lead o srikingly differen economic developmen pahs. We did his by comparing wo scenarios, called low qualiy (LQ) and high qualiy (HQ), which differ because once new secors are creaed heir oupu qualiy remains consan in he former (LQ) while i keeps increasing in he laer (HQ). We show ha he LQ scenario leads o a higher rae of employmen growh and o an iniially higher rae of income growh bu wih persisenly low wages, oupu qualiy and secoral demand while he HQ scenario leads o income being iniially lower bu afer a while overaking ha of he LQ one. 23

25 On he basis of hese resuls i seems as if he hisorically observed developmen pah resembles a combinaion of he LQ and HQ scenarios wih a ransiion from LQ o HQ (LQ HQ) occurring afer a given period. This ransiion is explained by he fac ha iniially he LQ scenario would have ensured boh a higher employmen and a higher income, bu ha afer a period he HQ scenario overakes in erms of income generaion. To explain he (LQ HQ) ransiion we hypohesize a mechanism of economic developmen in which high oupu qualiy, high compeencies and high wages co- evolve and muually reinforce one anoher o provide boh he required echnological capabiliy and he purchasing power. Thus, he (LQ HQ) ransiion ogeher wih he dynamics of populaion growh explains o a considerable exen he delayed oucome of he ransiion from necessiies o imaginary worlds. Furhermore, we invesigae he ineracion of populaion growh and educaion by assuming ha growh of he laer reduced he rae of growh of he former. Thus, no only he falling rae of growh of populaion induced by growing educaion conribued o enhancing individual consumpion bu i also reduced unemploymen, hus compensaing one of he weaknesses of he HQ scenario relaive o he LQ one. These resuls depend on wo cenral feaures of our TEVECON model: i) economic developmen is inrinsically linked o srucural change and i keeps occurring due o he capaciy of he economic sysem o keep differeniaing by creaing new secors and by coninuously increasing heir oupu qualiy and inernal differeniaion, ii) he long run paern of growh we analyze depends on he co- evoluion of a number of variables and no on he separae acion of any of hem. A number of policy implicaions can be derived from our model. For example, we can expec an economic sysem which has he capabiliy o creae new secors faser han ohers o experience higher growh raes. We can observe ha he mos successful developing counries of he pas fify years have applied a sraegy heavily emphasizing expor variey (Savioi, Nesa and Javaid 2010). Furhermore, he higher rae of produciviy growh of he USA wih respec o he EU during he period can be parly explained by heir superior capaciy o creae high ech firms in new secors enering hem a earlier imes when raes of growh of profis and of employmen are higher. This subjec is parly explored in he paper by Hoelzl and Janger (his issue). However, while a developmen sraegy based on oupu differeniaion in he double sense of increasing variey and of increasing secoral qualiy and differeniaion is one of he mos effecive economic developmen sraegies, oher ones are possible and compaible wih TEVECON. For example, counries can choose o increase heir produc qualiy or differeniaion more han heir overall oupu variey. The German model is a noable example of his sraegy. Anoher possible economic developmen 24

26 sraegy which we have no analyzed wih TEVECON bu which has been he objec of empirical sudies is heavily based on naural resources. In summary, he world economic sysem developed by increasing is oupu variey and is produc qualiy and differeniaion and i would no have experienced he observed paern and raes of growh if i had no differeniaed he way i did. This overall developmen mechanism creaed an economic environmen in which addiional sraegies based on produc qualiy or on naural resources became possible. The presence of co- evoluion in TEVECON has imporan policy implicaions. The posiive feedback loops occurring in co- evoluion involve he ineracions of differen variables. Thus, o exploi he advanages of co- evoluion one would expec policies and policy insrumens o focus on several ineracing variables raher han on each one of hem in isolaion. This implicaion bears a considerable similariy o he advice given by Borras and Edquis (his issue) o use policy mixes raher han single policy insrumens, an advice ha hey jusify on he basis of complexiy. Awareness of he mulifacor naure of economic growh is presen in he paper by Marrocu, Paci and Usai (his issue) alhough hey do no elaborae on he implicaions of he ineracions beween differen variables. ACKNOWLEDGMENTS We are graeful o Giovanni Dosi, Giorgio Fagiolo, Andrea Rovenini, Tommaso Ciarli, Marco Valene, Mauro Napoleano, San Mecalfe, Adam Szirmai, Jorge Niosi, Fabrizio Pariarca and o wo anonymous referees for heir commens. Of course, he responsibiliy for evenual errors remains exclusively ours. The research leading o hese resuls has received funding from he European Union Sevenh Framework ProgrammeFP7/ in he PICK- Me projec under gran agreemen n SSH- CT REFERENCES Acemoglu, D., Ziliboi, F. (1997), Was Promeheus unbound by chance? Risk, diversificaion and growh, Journal of Poliical Economy, Vol. 105, Aghion P., Howi P.(1992), A model of growh hrough creaive desrucion, Economerica,Vol. 60, Baumol, W.J. (1967) Macroeconomics of unbalanced growh: he anaomy of urban crisis, American Economic Review Vol. 57 (3), Ciarli T., A. Lorenz, M. Savona, and M. Valene (2010), The effec of consumpion and producion srucure on growh and disribuion. A micro o macro model, Meroeconomica, Vol. 61(1),