THE ECONOMICS OF IDEAS
4.2 THE ECONOMICS OF IDEAS
Beginning in the mid-1980s, Paul Romer formalized the relationship between the economics of ideas and economic growth.3 This relation- ship can be thought of in the following way:
Ideas h Nonrivalry h Increasing
h Imperfect
Returns Competition
According to Romer, an inherent characteristic of ideas is that they are nonrivalrous. This nonrivalry implies the presence of increasing returns to scale. And to model these increasing returns in a competitive environment with intentional research necessarily requires imperfect competition. Each of these terms and the links between them will now be discussed in detail. In the next chapter, we will develop the math- ematical model that integrates this reasoning.
A crucial observation emphasized by Romer (1990) is that ideas are very different from most other economic goods. Most goods, such as a smartphone or lawyer services are rivalrous. That is, your use of a smartphone excludes our use of the same phone, or your seeing a par- ticular attorney today from 1:00 P.M. to 2:00 P.M. precludes our seeing the same attorney at the same time. Most economic goods share this property: the use of the good by one person precludes its use by another.
If one thousand people each want to use a smartphone, we have to pro- vide them with one thousand phones.
3This basic insight is found in Shell (1967), Phelps (1968), Nordhaus (1969), and Romer (1986).
In contrast, ideas are nonrivalrous. The fact that Toyota takes advan- tage of just-in-time inventory methods does not preclude GM from tak- ing advantage of the same technique. Once an idea has been created, anyone with knowledge of the idea can take advantage of it. Consider the design for the next-generation computer chip. Once the design itself has been created, factories throughout the country and even the world can use the design simultaneously to produce computer chips, provided they have the plans in hand. The paper the plans are written on is rival- rous; an engineer, whose skills are needed to understand the plans, is rivalrous; but the instructions written on the paper—the ideas—are not.
This last observation suggests another important characteristic of ideas, one that ideas share with most economic goods: they are, at least partially, excludable. The degree to which a good is excludable is the degree to which the owner of the good can charge a fee for its use. The fi rm that invents the design for the next computer chip can presumably lock the plans in a safe and restrict access to the design, at least for some period of time. Alternatively, copyright and patent systems grant inventors who receive copyrights or patents the right to charge for the use of their ideas.
Figure 4.1, taken in large part from Romer (1993), lists a variety of economic goods according to their degree of excludability and whether they are rivalrous or nonrivalrous. Both rivalrous and nonrivalrous goods vary in the degree to which they are excludable. Goods such as a smartphone or the services of a lawyer are highly excludable.
Goods that suffer from the “tragedy of the commons” problem are rivalrous but have a low degree of excludability.4 The classic example of such goods is the overgrazing of common land shared by English peasants during the Middle Ages. The cost of one peasant’s choosing to graze an additional cow on the commons is shared by all of the peas- ants, but the benefi t is captured solely by one peasant. The result is an ineffi ciently high level of grazing that can potentially destroy the com- mons. A similar outcome occurs when a group of friends goes to a nice restaurant and divides the bill evenly at the end of the evening—
suddenly everyone wants to order an expensive bottle of wine and a rich chocolate dessert. A modern example of the commons problem is the overfi shing of international waters.
4See Hardin (1968).
83 TH E E C O N O M I C S O F I D EAS
Operations manual for Wal-Mart stores Computer code for a
software application Encoded cable TV
transmission
National defense Basic R&D
Calculus Fish in the sea
Sterile insects for pest control Lawyer services
Degree of excludability
HIGH
LOW
Rivalrous goods
Smartphone
Nonrivalrous goods
FI G U R E 4.1
ECONOMIC ATTRIBUTES OF SELECTED GOODSSOURCE: This is a slightly altered version of Figure 1 in Romer (1993).
Ideas are nonrivalrous goods, but they vary substantially in their degree of excludability. Cable TV transmissions are highly excludable, whereas computer software is less excludable. Both of these goods or ideas are essentially a collection of 1’s and 0’s ordered in a particular way so as to convey information. The digital signals of an cable TV transmission are scrambled so as to be useful only to someone with an appropriate receiver. In contrast, computer software is often “unscram- bled”: anyone with an Internet connection can download a version of Linux for free. Digital rights management (DRM) on music, movies, or software is an attempt to keep those items excludable, but once the DRM is cracked these items can be shared without cost. Similar con- siderations apply to the operating manual for Wal-Mart. Sam Walton details his ideas for effi ciently running a retail operation in the manual and gives it to all of his stores. However, some of these ideas may be copied by an astute observer of Wal-Mart’s business behavior.
Nonrivalrous goods that are essentially unexcludable are often called public goods. A traditional example is national defense. For
example, consider the idea of a ballistic missile shield that would pro- tect the United States from any incoming warheads. If the shield is going to protect some citizens in Washington, D.C., it will protect all citizens in the nation’s capital; ballistic missile defense is nonrivalrous and unexcludable. Some ideas may also be both nonrivalrous and un- excludable. For example, the results of basic R&D may by their very nature be unexcludable. Calculus, our scientifi c understanding of med- icine, and the Black-Scholes formula for pricing fi nancial options are other examples.5
The economics of goods depends on their attributes. Goods that are excludable allow their producers to capture the benefi ts they produce;
goods that are not excludable involve substantial “spillovers” of bene- fi ts that are not captured by producers. Such spillovers are called exter- nalities. Goods with positive spillovers tend to be underproduced by markets, providing a classic opportunity for government intervention to improve welfare. For example, basic R&D and national defense are fi nanced primarily by the government. Goods with negative spillovers may be overproduced by markets, and government regulation may be needed if property rights cannot be well defi ned. The tragedy of the commons is a good example.
Goods that are rivalrous must be produced each time they are sold;
goods that are nonrivalrous need be produced only once. That is, non- rivalrous goods such as ideas involve a fi xed cost of production and zero marginal cost. For example, it costs a great deal to produce the fi rst unit of the latest app for your phone, but subsequent units are pro- duced simply by copying the software from the fi rst unit. It required a great deal of inspiration and perspiration for Thomas Edison and his lab to produce the fi rst commercially viable electric light. But once the fi rst light was produced, additional lights could be produced at a much lower per-unit cost. In the lightbulb examples, notice that the only reason for a nonzero marginal cost is that the nonrivalrous good—the idea—is embodied in a rivalrous good: the materials of the lightbulb.
5Fischer Black and Myron Scholes (1972) developed an elegant mathematical technique for pricing a fi nancial security called an option. The formula, the basis for the 1997 Nobel Prize in Economics, is widely used on Wall Street and throughout the fi nancial community.
85 TH E E C O N O M I C S O F I D EAS
This reasoning leads to a simple but powerful insight: the econom- ics of “ideas” is intimately tied to the presence of increasing returns to scale and imperfect competition. The link to increasing returns is almost immediate once we grant that ideas are associated with fi xed costs. To give a more concrete example, the “idea” underlying the next blockbuster pharmaceutical (a common cold vaccine, let’s say) requires a one-time research cost. Once it is developed, each pill is produced with constant returns to scale: doubling the raw materials used in the drug and the labor to package it will double production. In other words, this process can be viewed as production with a fi xed cost and a constant marginal cost.
Figure 4.2 plots a production function y = f(x) = 100 * (x - F) that exhibits a fi xed cost F and a constant marginal cost of production.
Think of y as copies of the cold vaccine pill (let’s call it “ColdAway”). In this example, F units of labor are required to produce the fi rst copy of ColdAway.6 Thus, F is the research cost, which is likely to be a very
UNITS OF OUTPUT y
UNITS OF INPUT x
1
F
y = f (x)
FI G U R E 4.2
FIXED COSTS AND INCREASING RETURNS6The careful reader will notice that this statement is only approximately right. Actually, F +1>100 units of labor are required to produce the fi rst pill.
large number. If x is measured as hours of labor input, we might assume that F = 10,000: it takes 10,000 hours to produce the fi rst copy of Cold- Away. After the fi rst pill is created, additional copies can be produced very cheaply. In our example, one hour of labor input can produce one hundred pills.
Recall that a production function exhibits increasing returns to scale if f(ax) 7 af(x) where a is some number greater than one—for example, doubling the inputs more than doubles output. Clearly, this is the case for the production function in Figure 4.2. F units of input are required before any output can be produced; 2F units of input will pro- duce 100 * F units of output. The increasing returns can also be seen in that labor productivity, y>x, is rising with the scale of production.
A common question about pharmaceutical pricing (and the pricing of lots of other goods including software, books, and music) is “If the marginal cost of production is very small, why is it that the product costs so much? Doesn’t this imply an ineffi ciency in the market?” The answer is that yes, there is an ineffi ciency—remember from your fi rst microeconomics class that effi ciency requires that price be equal to mar- ginal cost. However, the ineffi ciency is in many ways a necessary one.
To explain why, Figure 4.3 shows that the presence of a fi xed cost, or more generally the presence of increasing returns, implies that set-
UNITS PRODUCED
F
1
Average cost
Marginal cost
FI G U R E 4.3
FIXED COSTS AND INCREASING RETURNS87 I NTE LLE CTUAL P R O P E RTY R I G HTS AN D TH E I N D USTR IAL R E V O LUTI O N
ting price equal to marginal cost will result in negative profi ts. This fi g- ure shows the costs of production as a function of the number of units produced. The marginal cost of production is constant—for example, it costs $10 to produce each additional pill. But the average cost is declining. The fi rst unit costs F to produce because of the fi xed cost of the idea, which is also the average cost of the fi rst unit. At higher levels of production, this fi xed cost is spread over more and more units so that the average cost declines with scale.
Now consider what happens if this fi rm sets price equal to marginal cost. With increasing returns to scale, average cost is always greater than marginal cost and therefore marginal cost pricing results in nega- tive profi ts. In other words, no fi rm would enter this market and pay the fi xed cost F to develop the cold vaccine if it could not set the price above the marginal cost of producing additional units. In practice, of course, this is exactly what we see: drugs sell for tens or hundreds of dollars, when the marginal cost of production is presumably only fi ve or ten dollars. Firms will enter only if they can charge a price higher than marginal cost that allows them to recoup the fi xed cost of creating the good in the fi rst place. The production of new goods, or new ideas, requires the possibility of earning profi ts and therefore necessitates a move away from perfect competition.