New York Times - June 5, 1999
Revising Capitalism: Coorperative Innovation Steals Competition's Thunder By MICHAEL M. WEINSTEIN
Capitalism, every undergraduate student of economics learns, thrives on competition. The brilliant virtue of the invisible hand of competition is that it forces firms to reduce costs, cut prices and thereby enrich consumers. This engaging tale has buttressed every economics narrative since Adam Smith lucidly explained more than 200 years ago how competition channels the natural greed of individuals into serving the social good.
Now William Baumol, an economics professor at New York University, wants to rewrite the basic tale. Yes, competition creates wealth. But in his new formulation, price cutting becomes a sideshow. Innovation takes center stage as the "primary weapon of competition." And the key to innovation is a clever form of collaboration among rivals.
Innovation, the process of translating inventions and new ideas into commercial products, is largely responsible for the tenfold rise in the living standards of American families over the last 100 years, he says in a new manuscript. Baumol's contribution is not to emphasize the impact of innovation but to pinpoint how competition forces companies to make innovation routine, much as marketing and advertising are.
In Baumol's analysis, capitalism emerges as a system that hums because it has figured out how to make innovation humdrum.
Baumol shows how companies pour money not only into their own research and development but also into such operations by their rivals. Yes, their rivals. Firms participate in joint ventures that hire teams of researchers to develop technologies that the firms will share. They also engage in the largely unrecognized practice by which companies enter into technology-sharing compacts. Under these compacts, a company like IBM writes contracts with competitors, like Hitachi. The companies promise to license future innovations to each other for a set fee. That way, if Hitachi comes up with a spiffy next-generation disk drive, IBM is guaranteed the right to incorporate Hitachi's new drive in its own computers.
It might seem odd for an economist like Baumol to herald collaboration among potential competitors. By jumping into the arms of rivals, companies appear to dull their incentive to innovate on their own. After all, if they can imitate rivals, why bother to innovate on one's own?
To understand Baumol's point, put yourself in the place of IBM. You could try to piggyback off Hitachi's innovations, dismissing your own engineers. But that strategy would collapse. At the very least, you would be dishing out hundreds of millions of dollars each year to rivals without getting anything in return. Worse, Hitachi would soon drop the agreements, because they make sense only if it expects to get about as many new products from IBM as it provides to IBM.
Nor would it make economic sense to beef up your investment in innovations without entering technology-sharing contracts. If four or five of your major rivals share innovations among themselves, then they will generate lots of ideas, drowning out the efforts of your one research department. And anything you don't figure out on your own will be offered to consumers by all your rivals. You simply cannot afford to bear that risk. The compacts eliminate the threat that a misstep in the technology race will drive you out of business. Besides, Baumol says, the compacts generate licensing fees that have become "a substantial business activity in itself."
Baumol's analysis makes a bigger point, far beyond the benefits and costs to individual companies. Technology-sharing contracts also help the economy -- that is to say consumers -- by spreading the benefit of innovation far beyond the customers of any one company. You don't have to buy Hitachi to get the benefit of its breakthroughs.
Drawing on his career as a consultant as well as scholar, Baumol says "that of the 20 or so firms that engage in substantial research and development for whom I have consulted over the past few years, almost all had technology-sharing agreements of one sort or another with other firms in their industries." The managers of these companies, he says, often agreed to them reluctantly. But the scientists, especially the engineers, often required them as a condition of their employment: they simply refused to work for a company that would not allow them to communicate with their peers.
He points to a compact that Perkin-Elmer Corp., which sells scientific instruments using precision optics, has had with Hitachi for the right to license innovations that either company might adopt. Under the compact, each company provides a menu of innovations under development, any of which it promises to make available for a fee that often ranges from 6 to 7.5 percent of the price of the product that incorporates the innovation. Perkin-Elmer has entered compacts with about 100 other companies. United Technologies' Pratt & Whitney, a manufacturer of aircraft jet engines, has technology-sharing agreements with a rival, General Electric.
The computer industry, Baumol says, is littered with technology-sharing agreements. Baumol's point is that innovations are no longer left to historical quirk or random feats of genius. Rather competition has forced corporations to bring to market a steady diet of innovative products from their own scientists or, if not, from scientists working for their competitors.
Baumol's focus on innovation may not seem novel. Joseph Schumpeter and others made it the core of their theories of economic progress. But in fact, the Baumol formulation overturns the thrust of modern textbooks. The typical (dreary?) presentation starts with chapter after chapter about how upward sloping supply curves and downward sloping demand curves interact in idealized markets to determine prices. When all goes well, market prices produce efficiency, a wondrous social outcome whereby the economy churns out the most output possible with its limited amounts of labor, land and machinery. Nothing goes to waste.
But market prices do not produce wondrous results in the presence of imperfections like monopolies. One imperfection, called an externality, is crucial to understanding the important message of the Baumol manuscript. Markets go haywire when the impact of a trade between buyer and seller extends beyond the two parties directly involved.
Take innovation. The profit from innovation routinely leaks to third parties. A firm spends a lot of money bringing to market a clever new electronic organizer or tennis racket. Ten nanoseconds later, another firm tears the product apart and reverse engineers a variation that gets around the patent. So the first firm winds up making relatively little money, a heavy disincentive for would-be entrepreneurs.
Professor Edward Wolff, a colleague of Baumol at New York University, estimates that innovators can expect to earn about 10 cents a year from each dollar they invest. But because the innovation leaks to other companies and other sectors, the economy as a whole reaps a benefit of about 50 cents. The implication, according to the textbooks, is that capitalism provides entrepreneurs too little of the profit that investments create for the economy. So they invest too little in the development of products. Consumers suffer from high prices, restricted choice and delayed innovation.
The traditional analysis, then, says that capitalism blunders at generating innovation over the long run. Baumol's manuscript reverses this presumption. Competition forces firms to innovate, engaging in what Baumol says "is tantamount to a technological arms race." The technology-sharing compacts, by generating a steady flow of licensing fees for IBM, Perkin-Elmer and other innovators, turn innovation into a routine profit-making activity. The competitive system, he says, goes "a long way, perhaps all the way, toward generating the right amount of innovation." The compacts overcome leakage by pouring more of the economy's gains from innovation into the bank account of the innovator.
By reducing the risk of innovation (a company that goes down the wrong technological road can lease the innovations it did not come up with) and increasing revenues, technology-sharing compacts make innovation profitable, routine and plentiful. As proof, he points to nonmarket societies that generated plenty of inventions but few applications. Medieval China, for example, invented gunpowder, paper, the printing press and probably the compass and the water wheel. But these inventions failed to raise living standards until adapted into consumer products by societies that were less hostile to commerce. The genius of Western capitalism was to translate invention into the goods and services that enrich everyday life.
Baumol tells a tale rich in details about the market's use of collaboration to overcome problems of innovation. Along the way he turns standard analysis upside down. Textbooks congratulate markets for their short-run efficiency, even though the short run is nothing spectacular. Entrenched monopolies, labor-market rigidities, perverse management incentives and many other problems are pervasive. The standard analysis goes on to criticize the market for shortchanging innovation and growth, when in fact "spectacular growth is the market's outstanding accomplishment."