Classical economics (Fonseca, 2002, pp 11 - 12) --
Classical economic theory does not deal with the dynamics of growth, but rather with the functioning of markets as resource allocation mechanisms in which demand functions interact with supply functions to determine prices that balance supply and demand, so sustaining market equilibrium. Just as with classical physics, an economy is understood to move according to deterministic laws in which the future is a predictable repetition of the past and the question of innovation does not feature, other than as an unexplained shift in the supply function. Movement into the future proceeds in a regular manner according to the equivalent of natural laws. The purpose of the movement is to sustain a predictable state of equilibrium specified by the economic laws of supply and demand, the equivalent of natural laws.
When one talks about the nature and purpose of the movement of some phenomenon one is talking about teleology as the cause of the movement. Movement that is the repetition of the past with the ""purpose"" of sustaining equilibrium is ""Natural Law Teleology"" (Stacey et al., 2000). Classical economic thinking about market systems thus assumes Natural Law Teleology. Within market systems, classical economic theory conceived of people in a particular way, namely, as rational individuals. These rational individuals (economic man) were thought of as operating in a calculating way in markets driven by the laws of supply and demand. Each rational individual calculated the predicted economic consequences of every action as determined by the laws of the market, choosing those actions that maximized their individual utilities. Individuals were assumed to act as profit and utility maximizers and, because they behaved in this way, markets functioned efficiently to optimize resource allocation. Stacey et al. (2000) refer to this way of thinking as ""Rationalist Teleology"". This is a way of thinking about movement as being caused by the rational choices of autonomous individuals in order to achieve their chosen goals.
The point, then, is that classical economic theorizing is conducted within dual causal frameworks of Natural Law Teleology at the macro level of market clearing and Rationalist Teleology at the micro level of individual economic agency. In the former there is no choice or freedom and in the latter choice is reduced to a rational calculation. Both of these ways of thinking are incompatible with the notion of novelty or innovation.
The articulation and rigorous formulation of the 'classical' system of economics is attributed to David Ricardo, in the early 1800s.
Neoclassical economics (Fonseca, 2002, pp 12 - 14) --
In the neoclassical development of economic theory, which continued within the dual causal framework described above, innovation was incorporated as a variable in the supply/production function. Independent variables, or mechanisms, were identified as causes of innovation and it was then a short step to assume that managers, as rational calculating agents, could operate on at least some of these independent variables and so exercise control over innovation.
Innovation, then, was equated with independent technological and, less frequently, organizational changes, which were thought of as changing the position and shape of production functions, usually by replacing the labour factor of production with capital. Changes, intentional or otherwise, in the independent causes of innovation had the effect of altering production functions.
Consequent output and cost changes disturbed market equilibrium and market forces immediately came into play to produce a new equilibrium state. How the technological and organizational innovations came about in the first place were not explained in neoclassical economic theory, but simply taken as given causes embodied in capital assets or in the knowledge required to manage capital and labour resources. This way of thinking led to a search for the specific variables and circumstances that would cause innovation to occur and enable managers to control it.
Although Solow (1957) empirically identified the variable ""technical progress"" as a major explanation of growth, understood as shifts in production functions, it proved difficult to specify appropriate independent causal variables to explain ""technical progress"". Consequently, the cause of ""technical progress"" had to be represented as a ""residual"" in the mathematical models of economic growth; empirical studies showed that these residual variables accounted for 60 per cent of the growth and that 80 per cent of the growth attributed to labour productivity was due to technical development (Denison, 1962). In other words, the models simply showed that innovation was important and that it could not be explained. All that could be said was that innovations appeared and disturbed market equilibria, which were then restored by the operation of the laws of the market. However, it might take a long time for equilibrium to be restored and this could open up the possibility of temporary monopolies, so that innovation becomes a source of monopolistic power and more than ""normal"" profit. The rational assessment of potential monopoly profits then becomes the prime motivator of innovation activity.
The neoclassical understanding of innovation, therefore, represents a ""both ... and"" way of thinking. At one level, that of whole economies and markets, innovation is understood as a variable in the economic laws, a form of Natural Law Teleology, which produces efficient outcomes and sustains equilibrium states. At another level, that of the industry, innovation is understood as a choice that organizations make on rational grounds in order to secure temporary monopoly positions and so maximize their profit goals. This is Rationalist Teleology, which is also applied at the level of the individual manager. It is autonomous rational individuals who select innovations on the basis of rational predictions and calculations in order to maximize their organization's profits. Two different ways of thinking are thus employed, sometimes one and sometimes the other, depending upon the level of analysis. In one way of thinking innovation is understood as a variable in a deterministic market system driven by the equivalent of natural laws; in the other way of thinking it is thought of as a variable, the consequences of which rational managers can predict and hence choose to control. In this ""both ... and"" thinking any sense of the paradox of determinism and choice is simply eliminated.