Creation Myths

Does innovation require intellectual property rights?

Douglas Clement from the March 2003 issue

(Page 2 of 4)

Increasing returns therefore seem to argue for some form of monopoly, and in the late 1970s Joseph Stiglitz and Avinash Dixit developed a growth model of monopolistic competition -- that is, limited competition with increasing returns to scale. It's a model in which many firms compete in a given market but none is strictly a price taker. (In other words, each has some ability to restrict output and raise prices, like a monopolist.) It's a growth model, in other words, without perfect competition. The Dixit-Stiglitz model is widely used today, with the underlying assumption that economic growth requires technological change, which implies increasing returns, which means imperfect competition.

Stanford's Paul Romer formalized much of this work in the 1980s and 1990s, in what he called a theory of endogenous growth. The idea was that technological change -- innovation -- should be modeled as part of an economy, not outside it as Solow had done. The policy implication was that economic variables, such as interest and tax rates, as well as subsidies for research and technical education, could influence the rate of innovation. (See "Post-Scarcity Prophet," December 2001.)

Romer refined the ideas of Arrow and others, developing new terms, integrating the economics of innovation and extending the Dixit-Stiglitz growth model into what he called "new growth theory." In a parallel track, Robert Lucas, a Nobel laureate at the University of Chicago, elucidated the importance of human capital to economic growth. And just prior to all this growth theory work, Paul Krugman, Elhanan Helpman, and others integrated increasing returns theory with international trade economics, creating "new trade theory." Similar theories became the bedrock of industrial organization economics.

Central to Romer's theory is the idea of nonrivalry, a property he considers inherent to invention, designs, and other forms of intellectual creation. "A purely nonrival good," he wrote, "has the property that its use by one firm or person in no way limits its use by another." A formula, for example, can be used simultaneously and equally by 100 people, whereas a wrench cannot.

Nonrivalrous goods are inherently subject to increasing returns to scale, says Romer. "Developing new and better instructions is equivalent to incurring a fixed cost," he wrote. "Once the cost of creating a new set of instructions has been incurred, the instructions can be used over and over again at no additional cost." But if this is true, then "it follows directly that an equilibrium with price taking cannot be supported." In other words, economic growth -- and the technological innovation it requires -- aren't possible under perfect competition; they require some degree of monopoly power.

Undermining Convention

Economists prize economic growth but distrust monopoly, so accepting the latter to obtain the former is a Faustian bargain at best. With "Perfectly Competitive Innovation," Boldrin and Levine vigorously reject the contract.

Innovation, they argue, has occurred in the past without substantial protection of intellectual property. "Historically, people have been inventing and writing books and music when copyright did not exist," notes Boldrin. "Mozart wrote a lot of very beautiful things without any copyright protection." (The publishers of music and books, on the other hand, sometimes did have copyrights in the materials they bought from their creators.)

Contemporary examples are also plentiful. The fashion world -- highly competitive, with designs largely unprotected -- innovates constantly and profitably. A Gucci is a Gucci; knock-offs are mere imitations and worth less than the original, so Gucci -- for better or worse -- still has an incentive to create. The financial securities industry makes millions by developing and selling complex securities and options without benefit of intellectual property protection. Competitors are free to copy a firm's security package, but doing so takes time. The initial developer's first-mover advantage secures enough profit to justify "inventing" the security.

As for software, Boldrin refers to an MIT working paper by economists Eric Maskin and James Bessen. Maskin and Bessen write that "some of the most innovative industries today -- software, computers and semiconductors -- have historically had weak patent protection and have experienced rapid imitation of their products."

Moreover, U.S. court decisions in the 1980s that strengthened patent protection for software led to less innovation. "Far from unleashing a flurry of new innovative activity," Maskin and Bessen write, "these stronger property rights ushered in a period of stagnant, if not declining, R&D among those industries and firms that patented most." Industries that depend on sequential product development -- the initial version is followed by an improved second version, etc. -- are, they argue, likely to be stifled by stronger intellectual property regimes.

"So examples abound," says Boldrin. "That's the empirical point: Evidence shows that innovators have enough of an incentive to innovate." But he and Levine are not, by nature or training, empiricists. They build mathematical models to describe economic theory. In the case of intellectual property, they contend, current theory says innovation won't happen unless innovators receive monopoly rights, but the evidence says otherwise. "So what we do is to develop the theoretical point to explain the evidence," says Boldrin.

Rivalry Over Nonrivalry

A fundamental tenet of current conventional wisdom is that knowledge-based innovations are subject to increasing returns because ideas are nonrivalrous. Boldrin and Levine argue that in an economy this has no relevance. While pure ideas can be shared without rivalry in theory, the economic application of ideas is inherently rivalrous, because ideas "have economic value only to the extent that they are embodied into either something or someone." What is relevant in the economic realm is not an abstract concept or formula -- no matter how beautiful -- but its physical embodiment. Calculus is economically valuable only insofar as engineers and economists know and apply it. "Only ideas embodied in people, machines or goods have economic value," they write. And because of their physical embodiment, "valuable ideas...are as rivalrous as commodities containing no ideas at all, if such exist."

A novel is valuable only to the extent that it is written down (if then). A song can be sold only if it is sung, played, or printed by its creator. A software program -- once written -- might seem costless, Boldrin and Levine write, but "the prototype does not sit on thin air. To be used by others it needs to be copied, which requires resources of various kinds, including time. To be usable it needs to reside on some portion of the memory of your computer....When you are using that specific copy of the software, other people cannot simultaneously do the same."