IntellectualCapitalGrowthModel:UsingICMeasurementLogicon AKEndogenousModel

StevoPucar FacultyofEconomics,UniversityofBanjaLuka,BanjaLuka,BosniaandHerzegovina
stevo.pucar@blic.net
Abstract: The theory of intellectual capital has experienced a boom in the first decade of 21st century. Most of the researchworkinthisareafocusesonenterprisesandorganizations,althoughthereisaneffort,especiallylately,toprovide answers concerning development of national economy. This theory has a lot of potential to create new insights and it is expected that it becomes even more incorporated into mainstream economics. This paper is an attempt to incorporate intellectual capital theory insights into endogenous growth theory as part of modern macroeconomics. In this paper, simple AK endogenous growth model is used as a basis. The intellectual capital growth model presented here also takes A or Total Factor Productivity as an average total productivity but with one fundamental distinction. It is using the logic of Calculated Intangible Value and/or Knowledge Capital Earnings by Baruch Lev where higher than average returns indicatehigherintellectualcapital.ThemodelpresentedhereappliesthislogictoTotalFactor Productivity.Incaseswhere TFP is equal to the average, the intellectual capital performance is also equal to the average, and the model is with constantreturnsastheAKmodel.ButincaseswhereTFPislargerthanaverage,theintellectualcapitalperformanceisalso better than average, and the model is with increasing returns, and in cases where TFP is less than average, the intellectual capital performance is worse, and the model is with diminishing returns. The most important implication of the model is that savings and investments have a longterm effect on growth only if intellectual capital performance is equal or better thanaverage.Ifintellectualcapitalisworsethanaveragethereisnosuchaneffectbecauseofdiminishingreturns.Insuch a situation the policy should be first to increase intellectual capital to at least average performance and then to increase investments. Keywords:intellectualcapitalgrowthmodel,endogenousgrowthmodel,AKmodel,totalfactorproductivity,calculated intangiblevalue,knowledgecapitalearnings

1. Introduction
The theory of intellectual capital has experienced a boom in the first decade of 21st century. In 1997 Sveiby published his book "The New Organizational Wealth," Stewart published his book "Intellectual Capital" and Edvinsson and Malone published book "Intellectual Capital". After that and after Bontis and McMaster University, Hamilton, Canada organized the World Congress on Intellectual Capital, from 1998 until today we have an abundance of articles, books, studies and conferences dealing with intellectual capital. Most of the research work in this area focuses on enterprises and organizations, although there is an effort, especially lately,toprovideanswersconcerningdevelopmentofnationaleconomy.

On the other hand, the new growth theory or endogenous growth theory, as part of mainstream macroeconomicgrowththeory,arguesthateconomicgrowthisanendogenousresultoftheeconomicsystem, especially concerning relation of human capital and technology. What should be stressed here is that there is still an intensive work on developing new growth models, so that the endogenous theory still cannot be consideredcompleted.Thispresentsanopportunitytoincorporatenewinsightsfromthetheoryofintellectual capitalintotheendogenousgrowththeory.Thispaperisanattemptinthatdirection.

First part of this paper elaborates simple AK endogenous model as basis for new model that is presented in a third part. Second part of the paper explains intellectual capital measurement logic as basis for advancing AK model. Third part is presenting a new model Intellectual Capital Growth Model and at the end there are someconcludingremarks.

2. AKmodel
AK model is one of endogenous models within the macroeconomic theory of growth. Endogenous growth theory has emerged as an upgrade of the standard neoclassical theory of growth. Specifically, the neoclassical growthmodel,thesocalledSolowmodelisbasedonthelawofdiminishingreturns,wherecapitalandoutput percapitareachasteadystateregardlessoftheinitialconditions.

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 StevoPucar The key feature of the AK endogenous growth model (Rebelo, 1992, and others) is that this model assumes that there are no diminishing returns to capital. Unlike the neoclassical model, the AK model uses a linear modelinwhichtheoutputisalinearfunctionofcapital.

AK model is based on a simple premise. For each additional unit of capital, income will increase by constant amount, and the relationship between income and capital will always be proportional.To model this,it is only necessarytoassumethatshareofcapitalinfactorincomeequals1.Theincomewilldependonthecapital

orinpercapitaterms

(1)

(2)

Aisapositiveaveragethatreflectstheleveloftotalproductivity Kiscapital Lislabor

TheFigure1isshowingtheproductionfunction,savingsanddepreciationthesamewayastheSolowmodel.

Figure1:Productionfunction,savingsanddepreciationinAKmodel Inthismodel,therearenodiminishingreturnsoncapitalandproductionfunctionislinear.Withthegrowthof capital, output rises proportionately, and since savings are proportional to output, the savings function is also linear.ThedepreciationislinearasintheSolowmodel. The income here depends on the capital and the growth rate of output is equal to the growth rate of capital. First,growthofcapitalis(forthesimplicitywewillassumethatpopulationisconstant):

sisrateofsavings israteofdepreciationofcapital

k = sf ( k ) k (3)

Whenwesubstitutef(k)withAkweget: Growthrateofcapitalgkis:

k = sAk k (4)

k / k = sAk / k k / k
gk = sA

Sincegk=gythen

(5)

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gy = sA

(6)

The basic implication of the model is the fact that the savings function and the function of depreciation are straightlineswhichneverintersect.Asthereisnointersection,savingswillalways,exceptattheorigin,willbe higherofdepreciationandcapitalwillcontinuetogrow.

When we are talking about the AK model, the most interesting implication in terms of economic policy is the fact that the increase in the national savings rate raises living standards. Every public policy that increases the rate of savings accelerates economic growth. The model also implies a divergence between economies. If two economiesstartwithdifferentinitialcapitalstocks,thentheabsolutegapwillbeincreasing.

3. Intellectualcapitalmeasurementlogic
According to Bontis (1998) claims, the term "intellectual capital (IC)," was first introduced by John Kenneth Galbraith, who considered that, in addition to the classic, pure knowledge, creative knowledge is of great importance for the economic activity. The difference between the human capital and intellectual capital is in thefactthatintellectualcapitalisnotjustknowledgeandskillsthatcanbeacquiredbylearningandtraining.It isawholesetofintangibleassetsusedtocreatevalue.

Thetheoryofintellectualcapitalbegantobemorepresentininternationalpublicduringthelate1990softhe last century. At that time one of the pioneers in this field, Stewart (1997) described intellectual capital as a brandnewtopicforthatera,inwhichtherearealotofwandering.

Together with human capital, theory of intellectual capital is based on the structural and customer capital (Bontis,1998,EdvinssonandMalone1997,Stewart,1997,etc.).Structuralcapitaliscreatedbyworkofhuman capital in the past and it consists of patents, concepts, models, networks, systems, and organizational culture. Customer capital includes relationships with customers and suppliers, brand names, trademarks and reputationorimageofthecompany.

The study of intellectual capital means the study of the thing that is immaterial. Therefore the key problem in this area is its measurement. Unfortunately, the fact that it is intangible, regardless of the simplicity of the concept,becomesaproblemforresearcherswhenitisnecessarytomeasureit.

AccordingtoSveiby(2001,2010)therearefourcategoriesofmeasurementapproaches. Direct Intellectual Capital methods (DIC) asses the monetary value of intangible assets through identification of its various components. Components are directly evaluated individually and/or as an aggregatedcoefficient. Scorecard Methods (SC) also asses the intangible assets through identification of its various components. ThedifferencefromDICmethodisthatthereisnomonetaryvaluationsinceindicatorsofcomponentsare reportedinscorecards. Market Capitalization Methods (MCM) use difference between market capitalization and the book value asthevalueofintellectualcapitalofacompany. Return on Assets methods (ROA) divide average pretax earnings by the average tangible assets of the company and then compare it with its industry average. The aboveaverage earnings are divided by the averagecostofcapitalandtheresultisanestimatedvalueofintellectualcapitalofthecompany.

HerewewillpayattentiontoReturnonAssetsmethods(ROA).Ithasalwaysbeenrecognisedthatthebalance sheet of a company certainly does not represent the real value of an enterprise. Determining the value of a company by using Return on Assets methods has been common practice among investors for many years andisstillusedtoday. The method for ROA based intellectual capital calculation divides average pretax income into average assets employed over a period in order to establish the rate of return achieved by the enterprise. This rate of return is then compared to the industry average to establish the performance of the enterprise in relation to its peers. Where the return generated by the enterprise is higher than the industryaverage, this is deemed to be asaresultoftheintellectualcapitaloftheenterpriseandtheexcessreturnisdiscountedusinganappropriate

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 StevoPucar discount factor in order to arrive at a present value for intellectual capital or the intangible asset value of the enterprise.

Stewart(1995)explainsCalculatedIntangibleValuemethodologybyusinganexampleofcompanyMerck: Calculationofaveragepretaxearningsforthreeyears$3.7billion. Calculationofaverageyearendtangibleassetsforthreeyears$12.9billion. Dividingearningsbyassetstogetthereturnonassets(ROA)29percent. Calculation of industrys average ROA for the same three years. For pharmaceuticals the average is 10 percent. Calculation of the excess return. The industry average ROA is multiplied by the companys average tangible assets 10 percent x $12.9 billion. These are earnings of average drug company with the same tangibleassets.Thisissubtractedfromthecompanyspretaxearnings.ForMerckthisisanexcessof$2.4 billion. According to Stewart (1995), this is how much more that company earns from its assets than the averagedrugmanufacturer. Calculation of the threeyearaverage income tax rate, which has to be multiplied by the excess return. Thisresultissubtractedfromtheexcessreturntogetanaftertaxfigure.This isthe premiumattributable tointangibleassets.ForMerck,withanaveragetaxrateof31percent,thisis$1.65billion. Calculation of the net present value (NPV) of the premium. This is done by dividing the premium by an appropriate percentage, such as the companys cost of capital. Using an arbitrarily chosen 15 per cent rate,thisyieldsMerck$11billion.ThisistheCIVofMercksintangibleassets.

Knowledge Capital Earnings (KCE) is methodology proposed by Lev (2001). First, he calculates earnings of the company (an average of earnings 3 years before and the forecasted earnings for 3 years after). From that earnings, he subtracts earnings of financial assets using given average aftertax return on financial assets and earningsofphysicalassetsusinggivenaverageaftertaxreturnonphysicalassets.Theresultareearningsthat cannot be atributed either to financial assets or to physical assets. According to Lev (2001) these earnings are knowledge capital earnings. He is using these earnings to calculate intellectual capital of the company and variousotherindexesandratios.Itmustbeemphasizedherethattherateofreturnonfinancialassetsandthe rateofreturnonphysicalassetsaretakenasgivenaverages.

4. Intellectualcapitalgrowthmodel
4.1 Descriptionofthemodel
Underlying thought of the model presented here is an assumption that ideas, i.e. intellectual capital plays a crucialroleineconomicgrowth.Wewillbeginwithequations(1)and(2)showninAKmodel

orinpercapitaterms

A is a positive average that reflects the level of total productivity and represents all intangible factors of production,i.e.,ideas. Kiscapital,andrepresentsalltangiblefactorsthatareusedinproductionprocess,i.e.,things Lislabor Until now everything isthe same as in AKmodel. Now we makeacrucial distinction.We will express Ak in the followingway: Aik=( A k)(7) Aiistotalfactorproductivityforaspecificcountry

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A isaveragesupranationaltotalfactorproductivity(oftheworldorofgroupofsimilarcountriesorbasedon somespecificcriteria,structureofeconomy,etc.) is an exponent or power that shows value of output with TFP of specific country as an power of output withaveragesupranationalTFP We are now going to apply logic of IC measurement in explanation of this concept. In Calculated Intangible Value we use industry average ROA, use it to calculate earnings of average company within the same industry with the same tangible assets, compare it to actual ROA (same assets in both cases) and determine the differencewhichrepresentsperformanceofintellectualcapital.
In this growth model the same logic is used. Output A k represents output that would be produced with average supranational total factor productivity. Output AiK is actual output produced with country specific totalfactorproductivityusingthesamecapital.Therelationofthosetwooutputsisconsideredasanindicator ofintellectualcapitalperformanceinthismodel. Usingthislogic,powerisshowingtowhatextentintellectualcapitalperformanceofspecificcountryisbetter or worse than average intellectual capital performance. If =1 intellectual capital performance is equal to average, if >1 intellectual capital performance is better than average and if <1 intellectual capital performance is worse than average. Since is a power that shows a performance of intellectual capital we shallcallitIntellectualCapitalPower. Wearegoingbacktothemodel.Firstwewillformulatethemodel: (8)

The Figure 2 is showing the production function, savings and depreciation for this model with =1 when intellectualcapitalperformanceisequaltoaverage.

Figure2:Productionfunction,savingsanddepreciationwith=1 This model is with constant returns and behaves as simple AK model. With the growth of capital, output rises proportionately, and since savings are proportional to output, the savings function is also linear. The depreciationfunctionisalsolinear. The Figure 3 is showing the production function, savings and depreciation for this model with <1 when intellectualcapitalperformanceisworsethanaverage.

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Figure3:Productionfunction,savingsanddepreciationwith<1 Thismodelis withdiminishingreturns.Withthegrowthofcapital,outputfunctioniswithdiminishingreturns, andsincesavingsareproportionaltooutput,thesavingsfunctionisalsodiminishingreturns.Thedepreciation functionislinear.

The Figure 4 is showing the production function, savings and depreciation for this model with >1 when intellectualcapitalperformanceisbetterthanaverage.

Figure4:Productionfunction,savingsanddepreciationwith>1 This model is with increasing returns. With the growth of capital, output function is with increasing returns, andthesavingsfunctionisalsowithincreasingreturns.Thedepreciationfunctionislinear. Concerning growth rate, as similar as in simple AK model, the income will depend on the capital and the growth rate of output is equal to thegrowth rate ofcapital. This is whywe first haveto determine thegrowth rateofcapital.
First,wewillusetheequation(3)andsubstitutef(k)with( A k) toget:

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 StevoPucar Growthrateofcapitalgkis: Sincegk=gythen It has to be noted that is average/marginal product of capital calculated as ratio of output to capital (9)

(10)

(11)

(y/k). Now,forthecasewhen=1growthrateisdeterminedassimilarasinsimpleAKmodel:

(12)

The Figure 5 is showing the growth rate gy for this model with=1 when intellectual capital performance is equaltoaverage.

Figure5:Growthrategywith=1 The growth of output is constant here and can be continued infinitely. For the case when<1 growth rate is decreasingbecausewithgrowthofcapitalkoutputcapitalratio isdecreasing.

The Figure 6 is showing the growth rate gy for this model with<1 when intellectual capital performance is worsethanaverage.

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Figure6:Growthrategywith<1

The growth of output can be continued here only until investments become equal to depreciation. This is similartotheSolowmodel.

For the case when>1 growth rate is increasing because with growth of capital k outputcapital ratio

is

increasing. The Figure 7 is showing the growth rate gy for this model with >1 when intellectual capital performanceisbetterthanaverage.

Figure7:Growthrategywith>1 Thegrowthofoutputisincreasinghereandcanbecontinuedinfinitely.

The most important implication of the model is that savings and investments have a longterm effect on growth only if intellectual capital performance is equal or better than average. If intellectual capital is worse thanaveragethereisnosuchaneffectbecauseofdiminishingreturns.Insuchasituationthepolicyshouldbe firsttoincreaseintellectualcapitalperformancetoatleastaverageandthentoincreaseinvestments.

4.2 Discussionofthemodel
This model claims that if the country keeps up with growth of knowledge, ideas, technology, i.e. intellectual capital or, even better, pushes its boundaries, it will grow in the long term. On the other hand, if it fails to do so,itwillfacediminishingreturnsandgrowthproblems.

Itmustbeemphasizedherethatthismodelistheoneofthefirstattemptstointroduceintellectualcapitalasa concept to macroeconomic growth theory. Even concerning knowledge, macroeconomic growth theory did not include it as a concept for many years. In the early nineties, mainly based on the work of American economist Paul Romer (1986, 1990, 1993), a new paradigm, now commonly known as "endogenous growth theory"iscreated.

Romer's crucial contribution to economic theory is the creation of growth model in which ideas play a crucial roleineconomicgrowth.Romer(1993)dividesfactorsintoideasandthings.Thingsareallphysicalobjectsthat exist around us, whether natural or manmade. They are scarce, behave by the law of diminishing returns and cannotcreateeconomicgrowthbythemselves.Ontheotherhand,ideasarenotscarce.Heclaimsthathuman beingshaveunlimitedabilitytousenewrecipesforrearrangementofthings.Thefactofcentralimportance, accordingtoRomer(1993),isthatthepossibilitiesfornewideasarealmostinexhaustible.

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 StevoPucar As we said before, underlying thought of the model presented here is also an assumption that ideas, i.e. intellectualcapitalplaysacrucialroleineconomicgrowth.ThismodelisbasedontheassumptionthatTFPand intellectualcapitalaretwosidesofthesamecoin.

Sinceitwascreated,TFPistheoneofmostimportantissuesineconomicgrowththeory.heimpactofTFPon economic growth is also well documented. Among many others, Easterly and Levine (2002) find that Total Factor Productivity, measured as Solow residual, accounts for most of the income and growth differences across nations. The crucial problem of TFP is its real meaning. This is still an open question. TFP is still measured as a residual and is still a measure of our ignorance (Abramovitz, 1956). We still need deeper insightsofwhatTFPreallyis,sinceSolowresidualgivesusprettydismalnotionofit.Thestreamofpapersthat treatTFPinalternativewayasindexnumber(Cavesetal.1982;Fareeta.l1994;andothers)offersmorespace tocomprehendthisissue.

The similar thing is with intellectual capital, since its definition is also dismal. As noted earlier, Sveiby (2001, 2010) systemized many different approaches to intellectual capital. The one of them considers intellectual capital as the sum of human, structural and customer/relational capital. The other one is defining intellectual capital of a company as difference between its market capitalization and the book value. There is also an approach that relates intellectual capital to aboveaverage earnings. Within those 3 approaches Sveiby (2001, 2010)distinguishes42differentconceptsofintellectualcapitalanditsmeasurement.

Concerningnationalintellectualcapital,firststudieswerebasedonthemethodologycreatedbyEdvinssonand Malone (1997). Thus Rembe (1999), analyzed intellectual capital in Sweden. In other Scandinavian countries, similar projects were promoted (Malhotra, 2003). Israeli scientists have also identified the importance of intellectual capital for economic development (Pasher, 1999; Pasher and Shachar, 2007). A similar report was madeinPolandandwasbasedonthesamemethodology(Boni,2009).Anothergroupofstudiesexaminesthe macroeconomic impact of intellectual capital as an economic driver. There are several such studies. For example Bounfour and Stahle (2008) measure the economic effects of intellectual capital on the macro level using a large number of indicators, on the sample of 51 countries. Some other studies have applied measurement models that were originally developed for the micro level. Corrado et al (2009) estimate intangiblecapitalintheU.S.economyexpandedbyusingtheirownmethodologyformicroeconomicresearch. Recently, the large share of the national intellectual capital research use complex unique indexes created on thebasisofalargenumberofdifferentindicators.Thesemodelsalsorelyonmicroeconomicfoundations.The most common taxonomy that is used here is Edvinsson and Malone (1997). For example, Bontis (2005) has created a unique index that measured the situation in the Arab countries. Andriessen and Stam (2005) used a similar approach in assessing the state of intellectual capital in the European Union. All other studies of national intellectual capital used this methodology to a greater or lesser extent (Bounfour, 2005a; Lin and Edvinsson, 2011; Veziak, 2007). However, the key problem with the use of composite indexes is that they lack firm theoretical foundations which brings into question their validity (M'Pherson and Pike, 2001, Malhotra, 2003, Stahle, 2006). Based on our review of the literature, we can see that there is only one study that attempts to integrate this type of indicators in the framework of macroeconomic growth theory (Muhsam,1970).

SinceTFPisoneofthemostimportanttopicsinthetheoryofgrowth,akeydirectionincreationofthismodel was to connect the concept of productivity with the concept of intellectual capital. Concerning TFP, Romer (1990) sees it as set of instruction, designs or recipes, basically set of ideas for rearrangement of things. Although there are many definitions of intellectual capital, here in this paper we consider intellectual as a set ofideas(andrelations)usedtocreatevalue.

There is also more essential connection of these two concepts. The productivity, in essence, is the relation of output and inputs. Since it shows how much of output is created with given inputs, in value terms it entirely depends on the amount of new value that is created out of those given inputs. And the concept of intellectual capital is all about the creation of value. Intellectual capital represents an active transformation of knowledge into a new value, valueadded products or services. This is the reason why these two notions are linkedinthismodel.IfweprovethatthisistruethenintellectualcapitaloffersdeeperexplanationofwhatTFP really is and TFP could become the most important performance measure of intellectual capital on aggregate level.

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5. Conclusion
InoneofhisfamouspapersonideasandthingsRomer(1993)says:Anationthatlackstheknowledgeusedto createvalueinamoderneconomysuffersfromanideagap.Thisthoughtwasaleadingthoughtincreationof thismodel.Themodelpresentedheregivestheoreticalframeworkinwhichitisclearthatideasorintellectual capital performance, measured as productivity, is most important for a longterm growth. Intellectual Capital Powerisanindicatorofideagap.Ifitislessthan1,countrysuffersfromanideagap.

Whatcouldthismodelmeanintherealworld?Intuitively,thiscouldmeanthatmostenterprisesineconomies withlargerthan1,areleadersincompetitiveness.Intheseeconomiesenterprisesdothingsinmosteffective and efficient way, push boundaries of existing technologies, innovate and create new technologies. Also it is probable that most enterprises in economies with equal to 1 keep up with productivity changes or intellectual capital performance of their competition. In these economies most enterprises operate with averageeffectivenessandefficiency.Forexample,theycoulduseuptodatetechnologiesbutdonotinnovate enough to be able to push things beyond current technology. In both cases the policy would be to increase investments in order to achieve higher standard of living, since intellectual capital performance is enabling longtermgrowth.

On the other hand, most enterprises in economies with less than 1 probably lag behind productivity or intellectual capital performance of their competition. In other words, in these economies most enterprises do thing in less effective and efficient way or use older technologies. These economies suffer from an idea gap and, as we said, the policy should be first to increase intellectual capital performance to at least average and thentoincreaseinvestments.

In spite of the simplicity of the concept that is underlying the model presented in this paper, empirical testing will probably be much more difficult. The current growth accounting methodologies and data sets that are adapted to those methodologies do not offer too many possibilities for empirical testing of the model. This is becauseTotalFactorProductivity(TFP)ismostoftenempiricallymeasuredasSolowresidual,representingTFP growth rate. In order to make sense of this model, further theoretical and empirical work on TFP is needed especially using the intellectual capital theory. We need deeper insights of what TFP really is, since Solow residualgivesusprettydismalnotionofit.

Another problem is the definition of the supranational average values. It is an open question shall we use averagesoftheworldorofgroupofsimilarcountriesorbasedonsomespecificcriteria,structureofeconomy, etc.Thiswillneedacarefulanalysis,sincedifferentaveragescancompletelychangewholepicture.Inaddition toworkonTFP,thiswillalsoneedboththeoreticalandempiricalanalysis.

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