Chapter 4 The Economics of Ideas Charles I. Jones

Ideas, Technology and Growth Accumulation of physical and human capital have been key drivers of economic growth so far These models do not generate growth of per capita incomes in the absence of technological progress, i.e. without growth in A in the production function Technology, however, is left unmodeled We need an economic model of technology and technological improvement

What is Technology? Technology is a “black box” that translates inputs such as capital K and labor L, into output Y according to some level of technological development A. New ideas improve technology The wheel Tin alloys: bronze, tin cans, touch screens Electricity Wal-Mart Ford assembly lines

Ideas, Rivalry, Returns and Competition Romer: ideas are non-rivalrous Non-rivalry implies increasing returns to scale as a necessary condition for the production of ideas Increasing returns to scale implies imperfect competition

Rivalrous and Non-Rivalrous Goods Romer (1990): ideas are non-rivalrous Most goods are rivalrous Your typing on your computer excludes me from typing on your computer Seeing a doctor by two patients at a time is generally impossible Rival goods are the ones for which the use of the good by one person precludes its use by another Ideas are non-rivalrous Same inventory method can be used by Toyota and GM Computer chip design is basically common knowledge Management practices can be used by many stores and firms at the same time

Excludable Goods A good is excludable if the good’s owner can charge a fee for its use New design can be locked in a safe so as to make it excludable Coca-Cola recipe is excludable since its not common knowledge Legal protection of ideas’ ownership is possible, too Patents Copyright laws

Rivalry and Excludability

Common Resources Some goods are rival, but not excludable Tragedy of the Commons English peasants during Middle Ages shared land Grazing an additional cow or sheep involves Benefits: more milk or wool Costs: loss in land’s fertility Benefits all accrue to just one peasant Costs are shared by everyone Land in this example is rival, but not excludable The result is, grossly inefficient use of land that in the end becomes infertile

What Kind of Good are Ideas? Ideas are nonrivalrous: my usage of some sort of know-how is not precluding you from using the same know-how Ideas can be excludable to a varying degree Excludable ideas: Cable TV transmission SAS, Mathematica software: based on remote server connection Non-excludable ideas: Operating systems are easily copied even if protected with codes Newton’s physical laws

Public Goods Public goods are those goods that are non-rivalrous, and non-excludable. Examples of the public goods National defense Fundamental research Police protection Black-Scholes formula for pricing options

Non-Excludability and Externalities In case a good is non-excludable, it involves spillovers that are not captured by the producers. These spillovers are called externalities which can be positive or negative. Positive externalities: these goods tend to be underproduced Education Basic R&D National defense Negative externalities: these goods tend to be overproduced Grazing cows on shared land (tragedy of the commons) Steel production (environmental pollution)

Rivalrous versus Non-Rivalrous Goods Rivalrous goods must be produced each time they are sold Non-rivalrous goods, including ideas, have to be produced only once. Typically, the production of ideas involves substantial fixed costs of development Computer chips Light bulbs Gaming software Once produced, a non-rivalrous idea can be used at a very low marginal cost. Large fixed costs and low marginal costs result in increasing returns to scale.

Ideas, Increasing Returns to Scale, and Imperfect Competition Consider the following production function: y is output (e.g. new medical drug), x is input units (chemicals), F is the fixed cost (large, e.g. 10000) of the drug development. To produce the first unit, we need F+1/100 units of inputs (why?) The remaining units can be produced at just 1/100 This function is increasing returns to scale because of large F (check it). Input productivity y/x is also rising with scale of production (check it).

Increasing Returns to Scale and Inefficient Pricing We know that marginal cost pricing, i.e. P=MC, is efficient in the sense that there is no deadweight loss in this case However, are we justified to require that Microsoft charge us 0.01$ for its Windows 8.1 operating system (roughly the cost of copying one DVD)? It turns out that, in case P=MC is required for those industries where the fixed costs of production F are large, in most cases producers in those industries will judge it better to exit the industry at all.

Marginal Cost Pricing in Case Fixed Costs are Large Large fixed costs imply slowly decreasing average costs, i.e. Total costs/Output With increasing returns to scale, average cost is always above the constant marginal cost Marginal cost pricing means negative profits, so firms will do better exiting! It is socially inefficient to charge P>MC, but it is still better than to stop production at all

Intellectual Property Rights Clear and enforceable property rights are key to the successful operation of a market economy. Technological progress drives economic growth, and it depends on ideas that take a lot of time and effort to develop. In case inventors are unable to capture most of the benefits generated by their ideas, they will not invent. Patents and copyrights are legal mechanisms that allow the property rights protection, providing inventors with the monopoly power over their inventions. Patents and copyrights ensure excludability of inventors’ ideas.

Industrial Revolution and Intellectual Property Rights Sustained growth in income per capita has been only in place since about 1750 Development of intellectual property rights has been key to the modern economic growth and development Property rights to the benefits of invention provide individuals and firms with market incentives to engage in the innovative activity Intellectual property rights are best developed and enforced in the developed market economies. In contrast, these are virtually non-existent in the poorer part of the world.

Determining Longitude Determining a ship’s longitude is very important for navigation, but it was solved only recently Most people tried to solve this problem in the same way as the problem of latitude was solved, i.e. by observing stars By the mid-1700s John Harrison, a clock maker from England, suggested using a highly precise chronometer to keep the original time at the point of departure. (How does one determine when it’s noon without any clock or watch at all?) Incentives offered by the Spanish, Dutch and British governments seem to have been the major stimulus for this invention However, even to this day important inventions do not make their creators rich: e.g. the Internet

Number of Innovators The number of new ideas generated each period (year) is directly proportional to the number of people in the economy Since ideas are non-rivalrous, once generated, they increase productivity of everyone in the economy In this way, increasing population size can be beneficial to the economy, although it contradicts what we know from the analysis of the Solow model(s) However, Solow models are about the rivalrous goods, while ideas are non-rivalrous Thomas Malthus (1798) predicted stagnating living standards because he failed to take into account the non-rivalrous nature of ideas

How do we Measure Ideas? R&D expenditure Number of patents However: Some ideas are never patented Economic value of patents is not the same Some ideas do not appear as a result of R&D effort Wal-Mart operating mode, multiplex movie theaters, same price shops, department stores etc Still, R&D and patent data are a reasonable approximation

Patents A patent is a legal document describing an invention and entitling the patent owner to a monopoly over the invention for some period of time: 17 to 20 years. Number of patents grows exponentially The US takes the lead However, most of the increase in the number of patents is non-US Some inventions are never patented: for instance, Coca Cola recipe

Research and Development Level of resources devoted to R&D has increased The share of resources devoted to R&D has increased as well U.S.: 0.25% labor force in 1950 to 1% in 2006

Neoclassical Growth Models Ideas are a different class of economic goods because they are non-rivalrous Once invented, an idea increases everyone’s productivity The marginal cost of copying an idea is almost zero (CD software) As a result, production based on innovation is characterized by increasing returns to scale Increasing returns to scale implies perfect competition is no longer applicable since the only way to ensure innovation is to grant the inventor a monopoly over his invention Ideas are only partially excludable Private benefits motivate the inventors, not the social ones Patents and copyrights are legal means to motivate the inventors