Innovations Tuesday, Mar 16 2010 

There’s been some talk about innovations recently. “Innovation” is defined as “The act of introducing something new” by the The American Heritage Dictionary. Not only are innovations new things, but they are also useful things. Innovation is one of the greatest sources of wealth creation and increased productivity. Thus, the importance of innovation is critical to the study of economics. In fact, there is an entire doctrine of economics, called innovation economics, that explores the relationship between innovation and economic growth. The pioneer of this doctrine was Joseph Schumpeter, author of Capitalism, Socialism and Democracy. According to innovative economics, the primary source of growth is not the accumulation of capital, but rather innovation, particularly innovation that increases productive efficiency. Thus, the incentivizing of innovation is what’s critical for an economy. In this sense, Schumpeter thought capitalism was the best mode of production because it incentivized innovation the most. Today, several prominent economists have used the theories of innovation economics to explain the growth of economies.

What is absolutely clear is that innovations are beneficial. How beneficial they are compared to other sources of growth could be debated, but it’s generally widely agreed upon that innovations provide a benefit to society. For example, King Banaian, the chairman and a professor of the economics department at SCSU, says entrepreneurship, which is a major source of innovation, is a positive externality and “may do more to relieve poverty than social organizations.” It’s a positive externality because “the value of this is not captured as much by entrepreneurs themselves as by society at large.” For example, with the invention of Windows, society was benefited far more than Bill Gates was benefited. (In other words, the price one pays for innovations does not reflect the true benefit it brings.) Basically everyone agrees innovation is great for society.

However, there are also problems with the current system of innovation, or the environment in which innovation occurs. One issue that I’ve highlighted on this blog before is that of copyrights and patents. Patents and copyrights are tools used to incentivize innovation and entrepreneurship. However, as I mention in the post, patents and copyrights create what are basically government-granted monopolies. As very elementary principles of microeconomics show, monopolies are economically inefficient. This can have significant impacts in the real world. For example, “economic inefficiency” might be translated into “hundreds of thousands of Africans dieing.” That’s precisely the consequence of patents in the medical industry, which keep prices high and poor people out of the market for life-saving drugs. Thus, I think it’s important to keep in mind the real world implications when we use technical and theoretical jargon like “market inefficiency”; it has real effects.

Essentially, the argument I made in that previous post is that government interference in the market creates an inefficiency (one that has dire effects) and that government-granted monopolies are not the solution for incentivizing innovation, particularly in the medical industry. I raised this point in Dr. Banaian’s post, and I got derided for it. I was told I was “only looking at one side of the issue.” After all, there’s a benefit that patents and copyrights bring, in that they do incentivize innovation, which we’ve all agreed is a positive thing. I’ve acknowledge that. If patents and such do lead to the creation of innovation and entrepreneurship, then that is a positive thing. We might even agree that the positives of this “intellectual property” outweigh the negatives of them. But that still doesn’t mean that patents and copyrights are the best option to choose. That’s an important point to keep in mind.

What I believe is “only looking at one side of the issue” is ignoring the more harmful consequences of this type of government interference. If some of the consequences of patents truly are harmful, even if there is a net benefit, we should ask ourselves if there is a way to mitigate the harmful aspects of our incentives for innovations without mitigating the positive aspects of our incentives. If there is, then we ought to choose that option.

Even though I do believe government-granted monopolies (i.e. the result of patents and copyrights) are quite harmful, that doesn’t mean government should necessarily get out of the way. I still agree innovation and entrepreneurship should be incentivized and rewarded. After all, if we accept the arguments coming from innovation economics, innovation is the key to economic growth. So how do we incentivize innovation without the harmful effects of patents and copyrights? There are different ways, but one idea that is proposed by Joseph Stiglitz, a Nobel laureate at Columbia University, is what he calls “prizes, not patents.” One of the problems with the current system (what I call the “profit motive“) is that it does not incentivize the allocation of scarce resources into areas that are not profitable for private, profit-maximizing firms—even when there’s a tremendous social benefit in doing so. (In other words, public goods are underproduced in free markets.) One example is in the production of life-saving drugs for illnesses and diseases that afflict much of the Third World. A majority of the populations that are afflicted by these life-threatening conditions are poor, so there’s not a lot of profit to be found in selling them drugs. A prize system, which is discussed in more detail in Stiglitz’s book Making Globalization Work, would help mitigate this problem by offering a reward or financial incentive to those who produce important innovations, like life-saving drugs. Not only would it incentivize innovation, it would direct resources into areas that would otherwise would not be profitable but are still a great benefit to society. Explains Stiglitz, “Since governments already pay the cost of much drug research directly or indirectly, through prescription benefits, they could finance the prize fund, which would award the biggest prizes for developers of treatments or preventions for costly diseases affecting hundreds of millions of people.”

There are other ways governments can be (and, in fact, are) critical in the introduction of innovation, which is through development that comes straight out of the state sector. CNN has an interesting article about the three most important “innovations that changed America.” The reader is asked to pick the most important of three, which are “1. The building of the interstate highway system, 2. The blanketing of the United States with coast-to-coast television, 3. The introduction and spread of the Internet.” Voting is now over, but 58% of readers chose the Internet, 29% picked television, and 14% picked the interstate system (numbers were rounded). I would agree, the introduction and spread of the Internet was the most important innovation that changed not only America but also the world. But where did the Internet come from? It came out of the state sector. The Internet was developed by the public, and it was later transferred to the private sector so that private firms could make a profit off it (that’s why we pay for Internet today). What about the interstate system, which is “often said to be the biggest public works project in the history of the world,” according the CNN article? It’s basically the same thing. This great innovation in logistics was created by the state, as I was quick to point out in a previous post on transportation subsidies. In television, it may be less clear, but the government still played an important role, particularly in broadcast television and the introduction of communication satellites. What this suggests is that, while (private) entrepreneurship is an important source of innovation, so too is the public sector.

In fact, a great deal innovation comes from the state sector. The Internet and the interstate system are two very important examples, but there are many others. In particular, high technology either comes from or is critically supported by the state sector. Science and innovation are symbiotic, and a lot of science is funded by the public. MIT, for example, is a source of great innovation; while a private university, MIT receives are great deal public subsidies, particularly through grants under the guise of military contracts. Public universities are also responsible for a great deal of innovation in both technology and ideas. This is what we should expect. If entrepreneurship and innovation is a positive externality, as Dr. Banaian contends it is, then we should expect that it would be underproduced in a free market. This image from Wikipedia shows this concept graphically. If private markets underproduce important innovations, then it suggests the state could play (as it currently does) an important role in either producing or incentivizing these innovations, e.g. through Pigouvian subsidies.

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What’s wrong with government intervention? Saturday, Feb 6 2010 

Many things, the neoliberal will answer. Many neoliberals believe government intervention in markets result in inefficiencies. Interferences make the market unfree. Of course, free markets allocate resources efficiently, so you reduce inefficiency when the government interferes. That’s a fairly typical argument. You can look at all sorts of neat equilibrium models and graphs that might show this to be the case (particularly when you accept the assumptions on which they are based).

One problem that government can introduce is the reduction of competition. Competition within markets is believed to achieve better results (economic efficiency) than when there’s no or little competition. For example, society is better off when there exist perfect competition within a market than when there’s a monopolistic firm that exerts market power. (Perfect competition doesn’t actually exist in the real world, but it does in theories, so we restrict ourselves to theoretical discussion.) So government is decried for making markets less efficient. But, quite curiously, this criticism is very selective. We can’t have government enforcing a minimum wage, for example, because that creates an outcome that diverges from the market equilibrium (i.e. creates an inefficiency). At the same time, however, we need copyrights and patents to protect our works and government needs to protect this.

As I said, it’s selective and actually fairly ideological. One opposes government when it suits one’s beliefs and one supports government when it suits one’s beliefs. When you oppose it and when you support it is often reliant on your ideology. So let’s look at copyrights, which are widely supported by anti-government right wingers. It’s a form of protection. It’s something the government provides to producers that results in less competition. In other words, it makes the market less efficient. The technical term is called a “government-granted monopoly.” It provides the exclusive right to a firm or individual to produce something. If I want to produce (or reproduce) it, I’m not allowed to. Keeping to neoclassical economic theories, society is made worse off. Those on the right like to rail against “coercive monopolies,” but not this coercive monopoly. In this case, we need government. Specifically, we need government to protect our monopolistic power. So you can’t even begin to talk honestly about “free markets” when you’ve got government enforcing monopolies, yet “free markets” remain to be hailed.

So why do right-wingers support copyright? There are reasons. One reason to support government intervention is because free markets are inefficient. (You probably won’t it hear stated in this way.) It’s stated that copyrights, patents, and so on are required for innovation. If I can’t get the sole right to write a book (or this blog post), I won’t write it. That’s the argument. If people can simply copy a song file and torrent it to everyone for free on peer-to-peer networks, then I’ve got no incentive to produce the song. (Note: I wrote a letter to the University Chronicle in 2007 in support of music copyrights.) If we accept this, then we should probably accept that free markets aren’t perfect and require government intervention to work properly. That might be reasonable to accept. But should we really accept the argument that copyrights and such are necessarily required to incentivize production? Are copyrights really what incentivized the great works of Shakespeare, Mozart, Michelangelo, or Newton? Actually, they didn’t exist back then. And when you actually look at copyrights today, particularly in the music industry, it’s the not the original creator that retains those rights. Many famous creators of “intellectual property” actually forfeit their rights to corporations, usually even before the product is created. In fact, nothing I write on this blog is copyrighted; yet, I continue to write. Maybe nobody wants to reproduce what I write, but look at Wikipedia, the content of which is not copyrighted and yet forms the basis for one of the most successful Web sites and encyclopedias in the world.

However, there can also be very dangerous aspects of copyrights. When you simply say “the market becomes less efficient,” that’s one thing. But what this might actually translate into in the real world is hundreds of thousands of Africans dieing. That’s a consequence of patents. When you simply talk of it in terms of “efficiency,” you sort of remove the moral dilemmas of what’s actually being talking about. This is one of the criticism Joseph Stiglitz, a Nobel laureate at Columbia University, levels against patents for medicines and vaccines. In his book Making Globalization Work, Stiglitz devotes a chapter for an idea he calls “prizes, not patents.” Explains Stiglitz in the Post-Autistic Economics Review, “But the patent system not only restricts the use of knowledge; by granting (temporary) monopoly power, it often makes medications unaffordable for people who don’t have insurance. In the Third World, this can be a matter of life and death for people who cannot afford new brand-name drugs but might be able to afford generics. For example, generic drugs for first-line AIDS defenses have brought down the cost of treatment by almost 99% since 2000 alone, from $10,000 to $130.” For more of Stiglitz on intellectual property and medicines, please see this video or read the article I just linked to.

Stiglitz’s proposed solution is setting up a prize for developers who develop important life-saving drugs. He writes:

There is an alternative way of financing and incentivizing research that, at least in some instances, could do a far better job than patents, both in directing innovation and ensuring that the benefits of that knowledge are enjoyed as widely as possible: a medical prize fund that would reward those who discover cures and vaccines. Since governments already pay the cost of much drug research directly or indirectly, through prescription benefits, they could finance the prize fund, which would award the biggest prizes for developers of treatments or preventions for costly diseases affecting hundreds of millions of people.

Of course, the patent system is itself a prize system, albeit a peculiar one: the prize is temporary monopoly power, implying high prices and restricted access to the benefits that can be derived from the new knowledge. By contrast, the type of prize system I have in mind would rely on competitive markets to lower prices and make the fruits of the knowledge available as widely as possible. With better-directed incentives (more research dollars spent on more important diseases, less money spent on wasteful and distorted marketing), we could have better health at lower cost.

I think it should be clear now that government-granted monopolies are not the only way to incentivize production and there a lot of problems in the way contemporary copyrights are constructed. With the greater success of copyleft and open source in recent times, I think it’s time we begin to contemplate alternatives. The dispersion and sharing of knowledge—e.g. the very purpose of university—is of paramount importance to society. We should not be trying to restrict it through government interventions.