Understanding Innovation Economics: What Government Interventions Should (not) Be Taken?

The Wright's first aeroplane from ground to air took off 

A machine that was much, much heavier than air 

To the cheers of the crowd, up and airborne became...

- The Wright Brothers by Pacific Hernandez

Hold on a minute! What you've just read above is the common oversimplification about the concept of innovation, yet still a beautiful poem. To grasp the concept of innovation, we must first let go of the idea of a genius inventor who works alone, invents something amazing, and becomes wealthy from it. Innovation is not just a single moment of brilliance. Instead, innovation is:

• A process. It plays a fundamental role in bringing about new developments and advancements, and it is a concept that is continuously evolving.

• Also Systemic. Just like the 828 passengers from Netflix's Manifest expressed, "It's all connected!" innovation follows the same principle. It consists of networks of users, private firms, individuals, and government bodies.

Rather than turning the innovation narrative into a fantastical superhero story with simplified moments of sudden revelation and a perfect ending, the truth is that a host of problems often arise afterwards, as evidenced below.

Back in 1998, 39 multinational pharmaceutical companies, including Bristol-Myers Squibb and Merck, filed a lawsuit against the South African government -- which at that time had the highest HIV rates at around 5 million people (1 in 10 of the South Africans were HIV positive). Their aim was to prevent the country from importing affordable generic AIDS drugs from various sources worldwide. This action sparked widespread street protests in South Africa, with AIDS activists confronting then-US Vice President Al Gore, who had been involved in negotiations favoring the pharmaceutical companies. Chanting "Gore's greed kills!", the activists voiced their discontent. However, in September 1999, the US government, which previously had been big pharma's strongest ally, stated that it would not impose sanctions on impoverished countries affected by the HIV epidemic, even if these countries violated US patent laws, as long as they complied with international treaties. The pharmaceutical giants countered this by deploying numerous intellectual property rights lawyers to advocate for their cases. As a result, they took drastic measures such as closing factories in South Africa and canceling planned investments.

Innovation At A Glance: Basic Concepts

In order to fully understand the concept of innovation (or at least grasp its basics), we should look at how innovation seems so complicated through the lens of policymakers, and why it is so hard for other countries -- or take South Africa as our example -- to just copy the leading world innovation systems, the Silicon Valley and German Innovation System.

These aspects are:

1. External effects -- defined as a positive or negative effect of a production, consumption, or other economic decision on another person or people that is not specified as part of the market transaction (outside the contract). A firm's successful invention almost always has either positive or negative effects on the value of other firms' investments in the innovation process. 

2. Public goods -- in theory, a public good means it can be consumed by one person without reducing its availability to others (non-rivalry) and also cannot exclude others from consuming it (non-excludable). Innovation involves the generation of new knowledge through a blend of existing knowledge and creative ideas. It's important to note that since ideas and knowledge -- which currently have significant contributions to the so-called knowledge economy -- are generally considered as public goods (Cooke et al., 2006), e.g. providing access to "cooking recipes" for new users does not take away the value from the current users. This characteristic transforms the innovation process into one that utilizes public resources to create further public benefits, such as vaccines for COVID-19.

3. Economies of scale -- it is a condition when the cost per unit is decreasing as the firm produces additional units (or put simply when the long-run average cost is downward-sloping). It is commonly misidentified with increasing return to scale -- when doubling all of the firm's inputs of production would lead to more than doubles of the output (hence, we're talking about proportion, instead of unit). However, both concepts are connected to each other, as the shape of the long-run average cost depends on its production return to scale. These economies of scale are commonly found in industries with high fixed costs, typically in the knowledge-intensive sectors (we'll come back to this concept later). In other words, firms entering a knowledge-intensive market first (known as first-mover advantage) -- e.g. biotechnology, software, etc. -- often can capture the entire market (the so-called winners-take-all), at least temporarily.

As previously mentioned, knowledge-intensive innovation could lead to economies of scale. There are basically two channels: 

1. The supply side (first copy costs) 

The knowledge-intensive sectors are known for their relatively large fixed costs structure -- also known as first copy costs. A good real-world example is by looking at the best-selling music album of Michael Jackson called Thriller. According to discogs, the production cost reached $750.000 back in 1982 (taking into account inflation until now would equal more than twice of that amount!). However, it spent only less than $1 per CD for the marginal cost of producing additional copies. In addition, downloading the song would require zero additional cost.

The situation of these economies of scale on the supply side can be illustrated below:

Figure 1. Firm's Cost Structure in Knowledge Intensive Sectors (Source: CORE The Economy)

2. The demand side (network effects)

We can value knowledge more as more individuals make use of it. Take the easiest example, the languages. Presently, over a billion individuals are engaged in the process of learning English as a language, which is higher than the number of native English speakers by more than threefold. The widespread desire to learn English does not come from the language's inherent superiority or its simplicity in learning (as many of you may already be aware). Rather, it is primarily driven by the fact that a significant number of people across various regions of the world already communicate in English.

Put simply, the network effects occur as higher benefits are enjoyed for each user when the network of users increases. The implication of network effects, however, would also be a disincentive for any individual to be the first adopter of the new technology in which network effects occur. Even if you had all the knowledge and expertise to build a chat platform, it's hard to encourage users to adopt your new platform in the short term. Moreover, the second implication of network effects is that, if two versions (or more) of the typical technology are substitutable, then the one with the higher number of users will have a better position, even if it is less inefficient or its competitor has better quality -- commonly referred as winners-take-all competition.

To see this winners-take-all competition more clearly, take Sony vs JVC as an example. Sony's Betamax format was considered better than JVC's VHS in terms of picture and sound quality. However, Sony made a mistake in the early 1980s by restricting the recording time to only 60 minutes. This meant that if customers wanted to record a full-length movie using their Betamax, they had to change the tape in the middle of the recording. By the time Sony increased the recording length to 120 minutes, VHS had gained a much larger user base, causing the Betamax format to practically vanish.

However, many economists are currently concerned about the winner-take-all market outcome. The high reward enjoyed by only the "winners" of the market would lead to the concentration of wealth. This would eventually lead to higher inequality and inefficiency as the economy experienced "inequality of opportunity". 

The Role of Intellectual Property Rights: Invention vs Diffusion

As we all know, intellectual property rights take the role as protection of codifiable (means can be written down) and non-excludable (the use by others cannot be prevented) knowledge, with three most common forms: patents, trademarks, and copyright. All of these forms of intellectual property rights possess the same characteristic: The owner is given the exclusive rights to use the protected item for a specific period of time, creating a temporary monopolist.

Do intellectual property rights encourage or actually discourage innovation?

To answer this question, we must consider the two opposite implications:

• The incentive for Research and Development: The intellectual property rights would make the owner enjoy economic profits (called innovation rents), creating a temporary monopolist, and thus encourage other economic agents doing more R&D to also enjoy the innovation rents

• The barrier to new innovation and diffusion: The rights, however, would limit the adaptation of the innovation throughout society (called diffusion) and also limit the others to make improvements from any given products protected by the rights.

Look at the crucial innovation of history (pioneer of the first industrial revolution), the steam engine by James Watt which was patented in 1769, and later on a share in the patent was bought by Matthew Boulton. However, the patent was also used to prevent other steam engine designs -- such as Jonathan Hornblower's design -- which was more efficient than the Watt. Moreover, the United Kingdom experienced a significant increase in the installation of steam engines after the Watt-Boulton patent expired. While under Watt's patent, the country added around 750 horsepower of steam engines per year. However, in the 30 years following the expiration of the patent, England saw an annual installation of over 4,000 horsepower of steam engines. Notably, fuel efficiency, which had seen minimal improvement during the patent period, multiplied by five between 1810 and 1835 (Boldrin and Levine, 2010).

Another unique piece of evidence would be the Italian operas. The establishment of copyright protection in Lombardy and Venetia -- due to Napoleon's military victories -- for Italian operas in the 19th century would encourage more artistic creativity, implying the creation of more and better operas, compared to six other Italian states without copyrights. However, Petra Moser (2020) also presents evidence that Opera's copyright with a short-lived duration and narrow scope is more favorable than the one with too broad or too long-term intellectual property rights -- which may do "more harm than good".

Figure 2. The mean difference between the new Opera in the Italian States with and without copyright 1781-1820 (Source: Petra Moser, 2020)

Should the Government increase its spending on R&D?

Before jumping into this question, we must first take a look at the urgency and important element of government intervention. The provision of government-funded research is in a uniquely good position to take on high-risk, long-term projects, because it does not need to guarantee short-term returns. One of the examples would be the Space Race, an extensive battle of research and experiments to gain superiority in the space industry between the United States and the Soviet Union. In fact, all of our daily life products are mostly pioneered by government funding on early-stage research. The creation of the Internet in 1969 was from a project funded by the Defense Advanced Research Projects Agency (DARPA). Not to mention the GPS system, touch screens, and computer mouse, which are also part of the result of US government-funded research (Janeway, 2012). It also can make findings from research available publicly, diffusing new technologies much faster than those patented in the private sector.

From these examples, Mariana Mazzucato, pioneer of the so-called "Mission Economy", argues that the government plays a crucial role in supporting research and start-up technology companies. It goes beyond filling in the gaps where the market might not invest due to uncertain or distant returns, but also influences and shapes the activities of the private sector. According to her perspective, strategic investments made by the US government have contributed to the dominance of American companies in cutting-edge industries like digital technology and biotechnology. 

However, on the other hand, government officials, who may not be specialists in technology, may have difficulties assessing the profitability of an investment or the likelihood of success, and hence may not make sound investment decisions. Therefore, it is essential for governments to also undertake public consultations with industry specialists in their investment decisions.

Then, one question may also arise, "Does an effective innovation system always align with centralized government intervention?" 

The answer to the right institution lies in the characteristics held by the innovation process. As Jonathan Haskel and Stian Westlake argue, with the comparison between the Apollo program and the Rollaboard suitcase. When the synergies aspect (higher value from the combination with other property) is more dominant, decentralized markets and competition could be fostered in order to enhance the research and development process. Robert Plath, who was a pilot, had a clever idea: he decided to attach wheels to his suitcase. This simple innovation demonstrated the importance of combining different ideas in a unique way. Quoting from Haskel's book, "If all innovations were like the Rollaboard, what would really matter is not total investment in R&D but rather the very specific combinations we can make out of them"

Figure 3. The comparison between centralized and decentralized innovation (Source: Haskel's Lecture Video at the Institute for Policy Research)

A Work in Progress: What's Next?

Technological progress had significantly increased labor productivity since the Industrial Revolution, especially during the golden age of capitalism. However, in the past decade, the increasing labor productivity trend seems to have come to an end. This downturn in the productivity growth rate is pointed out by Robert Gordon (2015) as the era of "Secular Stagnation", which is seen by the prolonged low-interest rate level and GDP growth in advanced economies. Another explanation would be the premature deindustrialization phenomenon, in which the transformation from manufacturing to a low-value-added service reduces overall productivity growth. However, Erik Brynjolfsson and other economists disagree with the previous pessimistic view, expressing the term "second machine age" to describe the optimism in the future economy as artificial intelligence, machine learning, big data, and many other revolutionary technologies coming to the surface.

Figure 4. The growth rate of productivity over the long run (Source: Our World in Data)

As we stand at the crossroads of progress and uncertainty, one burning question ignites our imagination: 

"Can future innovations bring up solutions to the current issues of inequality, climate change, and beyond? "

Only time will tell...

Written by: Zulfandi Yahya | Economics 2021 | Vice Manager Economic Studies Division Kanopi FEB UI 2023/2024

References

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