Friday, August 6, 2010

Non-rival ideas: Great for growth theory, but not for growth practice

This long post is drawn in part from prior work of mine on entrepreneurship and economic growth including "The Simple Economics of Technology Entrepreneurship: Market Failure Revisited."I was prompted to write it by this article in The Atlantic, which put me over the limit of exasperation with uncritical views of the actual contribution to the study of development made by "new growth theory." 
If nature has made any one thing less susceptible than all others of exclusive property, it is the action of the thinking power called an idea… He who receives an idea from me, receives instruction himself without lessening mine; as he who lights his taper at mine, receives light without darkening me. That ideas should freely spread from one to another over the globe, for the moral and mutual instruction of man, and improvement of his condition, seems to have been peculiarly and benevolently designed by nature…
—Thomas Jefferson, Letter to Isaac McPherson, August 13, 1813

As anyone who has been within a mile of a macroeconomics course in the past two decades is well aware, the big idea in growth theory in the past 20 years is something called endogenous growth. This is the insight that economic growth to technological and organizational innovation doesn't come out of nowhere. It actually requires work and investment.

Yes, that's the big insight.

Anyhow, the device that allows societies to escape the inevitable boundedness of any given project or set of projects and grow far into the future is something call "increasing returns to scale." This property allows some outputs of human intiative--notably, new ideas--to add more to economic outcomes than it takes to produce them. Ideas are particularly interesting because they are, in technical parlance, "non-rival": one person's use of an idea does not diminish its usefulness to someone else. As Thomas Jefferson noted two centuries ago (see above): "He who receives an idea from me, receives instruction himself without lessening mine; as he who lights his taper at mine, receives light without darkening me." Credit for this insight usually goes to Stanford economist Romer, on the based of set of more-or-less papers based on his dissertation that he published between 1986 and 1994.

This concept of non-rival ideas is intuitively obvious and seemingly interesting--even if it wasn't really Romer's. (Ref. the work of Karl Shell.) Only one problem: In it's usual application to growth, it's mostly wrong.

Here's why: While codified knowledge (books, published patents) may be non-rivalrous, in most cases it is either excludable (patents, documents protected by trade secret) or not directly applicable to production (basic research papers). The exceptional cases of published, unprotected "designs" are for obvious reasons, not likely to offer significant opportunities for entrepreneurs--unless combined with other information in novel and not easily imitable ways. (The phenomenon of "orphan drugs" is illustrative.)

Furthermore, patent protection is available to innovators in all industries, yet significant inter-industry differences exist in the extent to which patents allow persistence of profits. The differentiation is due to ease of imitability, which in turn relates to technological complexity. As MIT economist Rebecca Henderson and colleagues noted in a paper a decade ago:
[R]apid imitation of new drugs is difficult in pharmaceuticals for a number of reasons. One of these is that pharmaceuticals has historically been one of the few industries where patents provide solid protection against imitation. Because small variants in a molecule's structure can drastically alter its pharmacological properties, potential imitators often find it hard to work around the patent. Although other firms might undertake research in the same therapeutic class as an innovator, the probability of their finding another compound with the same therapeutic properties that did not infringe on the original patent could be quite small."
With regard to codified knowledge that is partially excludable, a critical issue is the extent to which partial imitation, or copying, preserves the quality of the original. In many, perhaps the majority, of economically important contexts, it will not.

In recent years economists, sociologists, geographers, and historians have addressed the transmission of knowledge, particularly increasing returns due to knowledge spillovers, in a large and varied literature. The empirical work on knowledge spillovers and parallel historical work have documented what the theorical work largely missed: the decline, during the twentieth century, of small scale craft-based production, and the corresponding rise of science based innovation and complex system development projects.

Consider Alfred Marshall's formulation of knowledge would be "in the air," frequently cited as the original articulation of the concept of knowledge spillovers. For craft-based production---glass making in Bohemia (Czech Republic), Champagne in Rheims (France), windmill production in Herning (Denmark)---there are solid reasons to believe that knowledge is "in the air." Masters share tacit knowledge with apprentices, whose core capability lies in replicating centuries-old techniques. New approaches are viewed with suspicion, and are accepted in to common practice only after considerable scrutiny. Science-based innovation and system development are another matter.

That Marshall's observations predated Romer's by nearly a century is of significance. The introduction of new products today (as opposed to a century ago) typically involves overcoming both technical and market risks. When products are based on truly novel technology, or create new markets, their introduction often requires new organizational forms. The knowledge that drives long term growth in a modern economy is thus detailed, highly technical, and context specific. It is an asset of the firm, whose development may be a consequence of explicit investments, "passive learning," or both. Ideas that are easy to copy will do not represent opportunities for entrepreneurs.

Yet to the extent that the knowledge developed by an incumbent firm is the solution to a complex problem, even slightly imperfect copying will likely lead to substantially degradation of performance. Active investment may be required to develop the "absorptive capacity" needed to make use of the information.

Whether knowledge about modern science based innovations is "in the air" or not is---literally and figuratively--immaterial. Only specialists will understand what it means.

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