Closing the loop in a circular economy: Saving resources or suffocating innovations?

Policymakers around the world are increasingly embracing the idea of a “circular economy” (CE), an economy built on the principle of reuse of materials and produced goods through recycling, refurbishing, and extended product life. By using less new materials per unit of value added, a CE is considered good for both the environment and the economy. Yet closing the material loop also changes the structure of the economy and the incentives for labor- and resource-productivity enhancing innovations. The overall economic impact is thus not so clear. This paper develops a two-sector endogenous growth model with Schumpeterian innovation, in which the primary sector continuously develops new products and uses primary resources in production, while the secondary sector refurbishes retired products for reuse. We show that increased refurbishing increases short-run consumption, but reduces resource prices (relative to wages) and crowds out the incentives for developing new, possibly less resource-intensive products. If innovations are strongly resource-saving, raising the refurbishing rate leads to a net economic loss.