The Economics of Ideas

Econ402, Spring 2004 Prof. Lutz Hendricks,

December 8, 2004

What is Technology?

Technology determines how inputs are transformed into outputs. Example: In the production function
Y =K

(AL)1

(1) is also part of the

A is an indicator of technology. But technology.

Ideas are improvements in technology. .

Examples of ideas:

Designs for new products: the Pentium chip, the steam engine,...

New ways of organizing production: Walmart, the assembly line.

We need to think about how ideas are developed.

What are the incentives?

Do the innovators reap the benets of new ideas?

The Economics of Ideas

We can summarize the key insight as:

Ideas
) )

Nonrivalry

Increasing Returns
)

Scale eects

Scale eects mean: larger economies produce more innovations.

The basic intuition: Producing ideas implies a xed cost. The xed cost must be recovered by selling products at a prot. In a larger market, innovation is more protable.

2.1

Nonrivalry

The fact that I use an idea does not reduce your ability to use it at the same time. Most goods are rival: computers, cars, etc. Which goods are non-rival?

Goods that embody knowledge.

Software.

Calculus.

Production methods (just-in-time production, assembly line).

2.2

Increasing returns

How does nonrivalry lead to increasing returns? Imagine that output is produced from rival inputs (X ) and ideas (A):
Y = F (X; A)

(2)

Replication implies constant returns to X :

If I can produce Y with one factory X and idea A, then I can produce Y with factories and idea A:
F ( X; A) = F (X; A)

(3)

But then: Setting up duces more than Y .

factories and using

ideas pro-

F ( X; A) > F (X; A)

(4)

Therefore returns to all factors are increasing.

2.2.1

Fixed costs

With R&D as the nonrival input, A is a xed cost. One rm invents and pays the R&D cost. Then marginal costs are constant: Replicate the rival X inputs only. But setting up more rms that share the idea leads to increasing returns.

Example: Software. Develop a new software package at a xed cost F . CD factories produce times as many CDs. Constant returns to the rival inputs. But also multiplying development inputs F by yields even greater output. Increasing returns to all inputs. .

2.2.2

A production function with xed costs

Pay the R&D cost F once. Then produce with constant marginal cost a:
y = f ( x) = a ( x F)

(5)

This has increasing returns to scale:

f ( x) = > f (x) + aF f ( x)

Average productivity is rising with the scale of production:

y=x = a F=x

(6)

Unit cost is falling: Unit cost =

px y

(7)

Marginal cost is constant: Marginal cost = p=a (8)

10

2.3

Imperfect competition

How do increasing returns lead to imperfect competition?

Perfect competition: Firms are price-takers: Given the market price, rms supply any amount of the product. Prices are driven to marginal costs. With increasing returns: marginal costs are below average costs. If prices equal marginal costs: rms incur losses.

Imperfect competition: Firms have some market power and can raise price above marginal cost. Each unit sold makes a prot. This prot is needed to cover the xed cost F .

11

2.4

Excludability

Does it matter that goods are non-rival? Example: Satellite TV.

The content is non-rival.

But DirecTV encrypts its content and therefore prevents non-paying users from enjoying the product.

In general: rms can exclude users who do not pay for the nonrival good. .

12

2.4.1

Rivalry vs. Excludability

Exclusion solves one problem of nonrivalry: inventors reap the benets of innovation.

But exclusion is itself ine cient.

Others need to replicate an existing innovation.

Exclusion does not solve the problem of imperfect competition and pricing above marginal cost.

13

Intellectual Property Rights

A key problem for policy: How to set the right incentives for innovation? Most innovations are not fully excludable. Some innovations provide knowledge spillovers: they facilitate other innovations. Then innovators reap only a fraction of the social value they create. Example: Apple invents the overlapping windows user interface. Microsoft copies it. The role of intellectual property law is to regulate copying of innovations.

14

3.1

IPRs and Modern Growth

Sustained growth is a modern phenomenon.

15

3.1.1

Lack of IPRs

Why did growth fail to take o until 1850? One reason: IPR protection did not become rmly established until the 19th century. Until then: Fundamental innovations did not generate large payos for the inventors. Example: The chronometer for measuring longitude.

16

3.2

Data on Ideas

How to measure ideas? We only have rough measures of inputs to and outputs of innovation. Inputs:

Expenditures on R&D.

Number of scientists and engineers.

Outputs:

Number of patents issued.

17

3.2.1

Patents

The number of patents has sharply increased, especially after WW2. The fraction of U.S. origin patents is shrinking.

18

Caveat: Many ideas are not patented.

Trade secrets: the formula for Coca Cola. Patenting would reveal too much information to the competition.

Basic science: the laser, quantum mechanics.

Tacit knowledge: how to manage and organize Microsoft ("organization capital").

19

3.2.2

R&D Inputs

The number of scientists & engineers engaged in R&D has increased (even as a fraction of the labor force).

R&D spending is quite small (2% of GDP).

Only 0.75% of the work force is engaged in R&D.

But actual inputs are probably much larger.

20

Summary

Productivity growth is due to innovation. Ideas are nonrival. This creates increasing returns to scale. Monopoly prots are required to pay for the xed costs of innovation. IPRs are needed to ensure that innovators reap the benets of new ideas. Monopolies and patents create ine ciency:

Ex post, the innovation should be made freely available to all (it should be sold at marginal cost: zero).

Products produced with the idea should be sold at marginal cost.

A key policy trade o: creating incentives for innovation vs. maximizing the benets from existing ideas.