A central proposition of New Growth theory is that, unlike land and capital, knowledge is not subject to diminishing returns.
The importance of knowledge
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.
Public Utilities and infrastructure
Essential utilities like electricity, gas, and water are, 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.