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Entrepreneurship, Innovation, and the Growth Mechanism of the Free-Enterprise Economies
Edited by Eytan Sheshinski, Robert J. Strom & William J. Baumol

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Introduction

EYTAN SHESHINSKI AND ROBERT J. STROM

THE FREE-ENTERPRISE ECONOMIES, whatever their imperfections, have succeeded in one task to a degree that has not been approached by any alternate form of economic organization, now or in the past. This primary accomplishment is their unparalleled record of technological innovation, in putting innovations to practical use, in elimination of obsolete products and processes, and in the resulting spectacular economic growth. The consequence has been remarkable progress toward reduction of poverty within countries where the free market has been left to direct the economy. Understanding the sources of this accomplishment is of the utmost importance, most immediately for the many countries of the world that are still far behind in per capita income. But even the industrialized countries have not yet succeeded in conquering poverty, with all of its serious consequences for the health and welfare of the society as well as that of the individual.

The essays presented in this volume are designed to increase our understanding of the general subject of the contribution of the market to innovation and economic growth.1 They take as their point of departure the recent book The Free-Market Innovation Machine: Analyzing the Growth Miracle of Capitalism (Princeton University Press, 2002) by William J. Baumol. That book focuses on the implicit partnership between independent entrepreneurs, who are the primary source of innovative breakthroughs in the marketplace, and high-tech corporations with their routinized research and development activities—whose primary and important accomplishment has been the steady improvement of the innovative products and processes contributed by independent entrepreneurs and the vast increase in the capacity and capability of those products and processes. The emphasis in this analysis is upon the critical role of the entrepreneur.

The essays in this volume are collectively a forum to analyze the growth in free-enterprise economies through the lens of Baumol’s “free-market innovation machine.” Each of the eight parts features a pair of chapters by leading scholars, who focus their discussion on the various themes developed in Baumol’s book. Each pair of essays (except in part I) is preceded by an introduction and comments by a third scholar.

Part I: Introductory: The Macroeconomics and Microeconomics of Growth

Two chapters by Kenneth J. Arrow and by Robert M. Solow provide the backbone for the remainder of the volume. In his essay, “On Macroeconomic Models of Free-Market Innovation and Growth,” Solow examines how aggregative growth theory models innovations and, accordingly, what can be said about macro conditions conducive to such processes. The creator of the “Solow Model”—the “workhorse” of neoclassical growth theory—argues that the approach to technical progress (TP) in models of aggregate growth, including those with “endogenous TP,” is mechanical and simple-minded, perhaps because of a fixation on steady states that confines the analysis to particular (“labor augmenting”) forms of TP.

Solow emphasizes the distinction between discrete, large-scale innovations (e.g., the combustion engine) and the more abundant small-scale, piecemeal innovations carried out internally with the aid of learning-bydoing or imitation. He speculates that a high-pressure (on capacity) economy with intensive innovative competition produces the best environment for increases in productivity. One hopes that empirical studies will shed light on this question.

Kenneth Arrow’s chapter, “The Macro-context of the Microeconomics of Innovation,” follows Joseph Schumpeter’s distinction between invention and innovation, the latter being the (costly) processing of inventive ideas. Social systems, in particular markets and science (knowledge), influence both. The major relevant institution common in market economies is a regime of property rights implemented by a legal system of licensing and patents. Competition in innovations endangers incumbent monopolists’ profits, thereby creating incentives for further innovation. This will lead, argues Arrow (following ideas promoted by Baumol), to an “optimal portfolio of innovations.” For effective dissemination of knowledge, Arrow points out, externalities created by the mobility of labor engaged in research and development (R&D) are important. More generally, the educational system, based on incentives that are only partially financial, provides trained users of knowledge.

It is noteworthy that Arrow and Solow, two leading theorists of economic growth, conclude that economic models have not provided deep insight into the process of innovation. Rather, they hope that ad hoc case studies will eventually shed sufficient light to enable construction of a cohesive theory on the relative importance of markets and knowledge.

Part II: Institutional Bases for Capitalist Growth

In this part, introduced by Michael Weinstein, Douglass C. North brings a historical perspective to the Baumol “free-market innovation machine” in a chapter titled “Institutional Bases for Capitalist Growth.” In considering the preconditions for capitalist society in both historical specifics and abstract concepts, North offers a valuable lens through which to view the issues this volume addresses. North, like Baumol, examines the underlying elements of a capitalist society. While Baumol looks at the realities of the individual players in capitalism, most importantly the interplay between the small independent entrepreneur-innovators and the large, established corporations, North focuses on a broad historical overview in the context of markets, transaction costs, and, most importantly, incentives. He explores the set of conditions that produced the free-market innovation machine and allowed it to create impressive growth in the West. North’s view complements Baumol’s work in his discussion of what kind of institutional structure will best accommodate such a machine. North asks what incentive structure will support the dynamic features of Baumol’s model, and answers that it is institutions that serve as the incentives to produce these features.

The second chapter in this part, Barry Weingast’s “Capitalism and Economic Liberty: The Political Foundations of Economic Growth,” focuses on the political requirements for a market economy that stimulates innovation and growth effectively. Weingast writes that the economic literature does consider the role of government, but implies that in developing countries the main problem for markets is inefficient government intervention that creates monopolies, market restrictions, and inefficiency. The implication for the creation of markets is that the necessary policy entails dismantling of political controls on markets and laws creating new markets. But Weingast emphasizes that the protection of property and hence the development of a robust economy arises only with the control of arbitrary government. This requires the creation of a set of political institutions that constrain politics so that it serves the interests of citizens. The political system must be properly constructed so that it is capable of sustaining a thriving market economy rather than preying on it.

Weingast posits that the problem in the developing world is that it has neither a capitalist system nor a government capable of sustaining one. Governments in the developing world all too frequently use their policy means to expropriate the wealth of some of their citizens rather than to provide market-enhancing public goods. This type of governmental opportunism is incompatible with a thriving capitalist market system. Further, successful constitutions create focal solutions to central coordination dilemmas over citizens’ rights. When citizens fail to agree about their rights, governments can take advantage of them by transgressing the rights of some citizens while retaining the political support of others. In contrast, constitutions that create focal solutions to citizen-coordination problems allow citizens to react in concert against potential transgressions, and thereby deter the government from abusing citizens’ rights.

Weingast concludes that market reform without corresponding political reform under development or in transition is doomed to fail: Without creating political reform compatible with markets, the political system is likely to hobble or prey on nascent markets, hindering their development into a thriving capitalist system.

Part III: Innovation in Modern Corporations

The essays in this part, introduced by Ying Lowrey, narrow the focus to address the issue of innovation in the modern corporation. Taken together, the two essays shed new light on aspects of the “David-Goliath” partnership (between the independent entrepreneur-innovators and the large corporations) that is necessary for Baumol’s free-market innovation machine to produce growth in capitalist economies.

In his chapter, “Endogenous Forces in Twentieth-Century America,” Nathan Rosenberg argues that science and technology have become a great deal more endogenous in twentieth-century American capitalism as a result of both organizational changes and associated changes in economic incentives. With its emphasis on the endogeneity of technology and science in the twentieth century, this essay illuminates many aspects of Baumol’s free-market innovation machine.

Rosenberg discusses some of the ways in which changes in the organization of research activities have contributed to growth, and he considers how and why both technology and science have been rendered a great deal more endogenous over the course of the past century. Like Baumol, Rosenberg looks to the key role of corporate research labs. Rosenberg credits the effective performance of the corporate research labs to a network of other institutions. These institutions include universities for their trained scientists, engineers, and graduate students who have continued to expand the frontiers of knowledge; federal government patronage, particularly in areas where it is clear that social returns will exceed private returns; and, finally, private philanthropic foundations, which were an especially important source of research support in the first half of the twentieth century. Rosenberg’s discussion, informed by more than one hundred years of economic history, presents a compelling story of the way in which the forces of technology have come to shape the various realms of science.

“Interfirm Collaboration Networks: The Impact of Network Structure on Rates of Innovation,” by Melissa A. Schilling and Corey Phelps, is grounded in the literature on interfirm and interorganizational networks that lead to the creation of knowledge and innovation. Schilling and Phelps examine the trade-off between creating bandwidth in the network through collaboration and cooperation versus creating greater reach by engaging a broader range of knowledge resources. They argue that small-world connectivity is a key to resolving the apparent trade-off, allowing bandwidth and reach to be achieved simultaneously. Utilizing data on alliance networks and patent output in a number of industries, they demonstrate how small-world properties may enhance the patent output of the network.

Part IV: The Continuing Role of Independent Innovators and Entrepreneurs

In this part, introduced by Sylvia Nasar, “The Small Entrepreneur,” by Boyan Jovanovic and Peter L. Rousseau, focuses on new firms and their response, more elastic than that of incumbent enterprises, to new technology and evolving incentives. Jovanovic and Rousseau start with an examination of the data on initial public offering (IPO) activity, and then provide a number of models of the timing decision for the execution of an IPO. Finally, they deal with indicators of inventive activity, focusing on the contribution of firms that are small and young. Examining the evidence, the essay notes that firms often introduce their first innovation soon after founding, but it may take decades before they list on a stock exchange. Moreover, these delays vary in length in different time periods. It is suggested that part of the reason may be secrecy—IPO prospectuses reveal business plans, so delay of an IPO may occur for the same reason a firm may avoid patenting an idea, instead developing it in secret.

The authors provide a number of neoclassical models in which, at the initial public offering, the public pays for the firm exactly what it is worth. However, Jovanovic and Rousseau conjecture that more can be learned by starting from the alternative hypothesis of waves of irrational exuberance. If such irrationality is likely, before their IPO, firms may be waiting in the wings to take advantage of it. In addition to its theoretical analysis, the essay’s analysis rests heavily on long data series and observations drawn from economic history. The data are used to show, for example, that overall the ages of the firms that are the market leaders vary considerably with time. The central conclusion is that, overall, firms that are small and young do better when there is faster technological change. Incumbents do well when it is “business as usual.”

The second chapter in part IV is William J. Baumol’s “Toward Analysis of Capitalism’s Unparalleled Growth: Sources and Mechanism.” Baumol starts by emphasizing the explosion in economic growth and innovation in the free-enterprise economies during the past two centuries, which far exceeds anything experienced under any other economic arrangements. He assigns primary roles to two groups: the independent inventors and entrepreneurs; and the large high-tech corporations. He cites suggestive evidence indicating that these two groups play very different and highly complementary roles in the processes of innovation and growth. The really revolutionary technological changes have been introduced preponderantly by independent inventors and then brought to market, often in relatively undeveloped form by the inventors’ companion entrepreneurs. Sometimes the inventions have been sold or leased to large enterprises for further development, while in other cases success has enabled the initiating small firms to grow and join the large enterprises that specialize in cumulative incremental improvements.

The large firms account for what is by far the preponderant share of R&D spending, at least in the United States, and while the individual innovative contributions that emerge from their laboratories are generally not revolutionary, when taken together over more extended periods of time, the values they contribute are often enormous.

The initial Industrial Revolution is attributed to the appearance of an abundance of productive entrepreneurs, who were attracted to innovation and productive activity by what may be deemed historical accident that changed economic institutions so as to reduce rent-seeking opportunities and increased the amount and security of the reward to innovative activity. In contrast, the more routinized innovative activity of the larger firms arose from market pressures as those firms began to use innovation as their primary competitive weapon, thereby inaugurating an arms race in which no participant dares to relax its innovative efforts. These changes in incentives for large firms and small are a unique product of the free-enterprise economy and, Baumol suggests, go far to explain the unprecedented economic accomplishments of the past two centuries. They also constitute a useful model for the developing countries as well as for the developed countries that are seeking to retain their economic leadership.

Part V: Dissemination of Technology and the Patent System

This section of the volume, introduced by Edward N. Wolff, begins with “Patents, Licensing and Entrepreneurship: Effectuating Innovation in Multi-Invention Contexts,” by Deepak Somaya and David J. Teece. This chapter is virtually a manual on choice in the management of patents and the role of the entrepreneur in the process. It focuses on the particular opportunities and challenges afforded by multi-invention (systemic) innovation. It starts off from the observation that, from the perspective of the patent-owner, a patent may have special value in a multi-invention context that calls upon special bargaining and negotiating skills. But for the actual or potential infringers, patents they do not own may play the role of roadblocks. The essay explores the solutions to the problems and the choices available to these two parties, a matter apparently not previously explored in the literature. The focus is not on the many legal tactics and maneuvers afforded by patent law, but on the broader strategic role played by patents in establishing competitive advantage at the enterprise level.

In the many industries characterized by a large numbers of inventions that are typically combined to yield their end products, the analysis grows complex and calls for dealing with matters such as design of a special framework for understanding issues of innovation and organization. This is used, for example, to analyze the implications of the transaction costs associated with licensing. Thus, Somaya and Teece note that licensing is particularly attractive in markets where the transactions costs are low, as they tend to be in component markets. The authors point out that this is so because the patent is simply bundled with a tangible good, and no separate patent issues normally arise.

The authors discuss the valuation problems entailed in licensing and technology trading, the issue of patent “ambushing,” in which the proprietor of a patent conceals its existence and lures rivals into unintentional infringement or other costly mistakes. Finally, having discussed the implications for the affected business firms, the chapter provides insights on the lessons for public policy. In sum, the chapter can be characterized as an illuminating manual on patent practice, strategy, and the pertinent policy issues.

In the second chapter in this part, Naomi R. Lamoreaux and Kenneth L. Sokoloff consider the innovation process in the United States in the nineteenth and twentieth centuries. Their essay, “The Market for Technology and the Organization of Invention in U.S. History,” provides two important and related contributions. They first discuss the division of labor, within-firm or among economic units, that will best support innovation and growth. Then they provide a thorough review of the U.S. patent system.

On the division of labor, Lamoreaux and Sokoloff note that the latter half of the nineteenth century was characterized by an expansion of trade in new technological ideas. This was followed by a rise in within-firm research and development labs in the first half of the twentieth century, accompanied by a decrease in market exchange. The authors report a more recent decrease in in-house research and development, as firms began acquiring outside technology.

The authors conclude that the advantage of a within-firm division of labor is its reduction of asymmetric information problems that restrict the ability of inventors to sell their new technological ideas at arm’s length. They also point out, however, that patent rights provide enough protection for inventors to engage in market exchange even if these rights are not fully enforced, and that contracting problems may reduce incentives for scientists and engineers to develop new technologies in-house.

As part of their analysis, Lamoreaux and Sokoloff provide a thorough discussion of the establishment of the modern U.S. patent system in 1836 and the economic consequences of this system. The authors’ historical analysis of the patent system concludes with a discussion of the increase in the rate of both patenting and trading in patented technologies in recent years. Consistent with the thesis of the free-market innovation machine, Lamoreaux and Sokoloff suggest that there is a growing consensus that these changes may be indicative of a rise in the technological dynamism of the U.S economy.

Part VI: Innovation and Trade

In this part, introduced by Yochanan Shachmurove, Ralph E. Gomory and William J. Baumol pose some very interesting questions about the impact of technological change and innovation on the setting of world trade and the nature of goods traded. Entitled “Innovation and Its Effects on International Trade,” their chapter considers the relevance of the standard textbook case for comparative advantage in a world in which natural advantages between countries play an increasingly insignificant role.

Based upon a standard linear Ricardo model of international trade, the authors attempt to determine the beneficiaries of trade in a world in which technology and innovation have changed the way global firms can bring together labor, capital, and knowledge. The authors conclude that often, although not always, a country is better off with a less developed trading partner. While only indirectly related to the central theme of this volume, this chapter calls into question some of the standard conclusions drawn from the comparative advantage model and offers an important perspective on issues of outsourcing and similar aspects of international trade.

The second chapter, “Innovation, Diffusion, and Trade,” is by Jonathan Eaton and Samuel Kortum. They investigate what underlies patterns of research specialization, studying how technology dissemination affects the volume of innovation. They begin by noting that only a small group of countries allocate much in the way of resources to inventive activity. While the countries that invest heavily in research tend to be wealthy, not all wealthy economies do so; some depend heavily on imported research results. Moreover, the most innovative countries have continued to be so for more than half a century. The article goes on to consider the determinants of a country’s research intensity, and the consequences of openness to trade and ease of dissemination of innovation.

The authors proceed to utilize a static Ricardian two-country model of technology, production, and trade. They consider the complicated case in which a disseminated innovation is used for the same commodity in both countries. In the case where technology is the same in both countries and diffusion can serve as a substitute for trade, trade ceases when similarities in efficiency in the countries eliminate the opportunities that would otherwise be offered by comparative advantage. The model is then expanded to incorporate dynamic elements and to take account of endogenous inventive activity.

The relatively simple Ricardian models yield the naturally corresponding results. If the differences between the productivity of research in the two countries exceed trade barriers, countries specialize in research in the pattern dictated by comparative advantage. But if differences in research productivity are below trade barriers, countries carry out their own research. Flows of knowledge replace flows of goods as the means by which countries benefit from one another’s innovations.

The essay provides results that are at least suggestive for policy. In the simplest case with no technology transfer, countries carry out the same amount of research, unaffected by size and research productivity, but the more productive countries are wealthier. With dissemination possible, the relation between productivity and trade barriers determines the allocation of research activity. Intermediate levels of diffusion introduce results with complex patterns of research specialization, so that among the most active researchers are both very small and very large countries.

Part VII: Finance and Innovation in the Free-Market Economy

This part, introduced by Alan S. Blinder, includes chapters by Robert J. Shiller and Burton G. Malkiel.2 Each of these contributions is based on both theory and direct experience. While Malkiel shows that efficient financial markets were responsive to and supportive of new technologies, Shiller highlights the yet unrealized promise of new innovative insurance markets.

Robert Shiller’s discussion in “Radical Financial Innovation” predicts radical extensions of risk management, pooling, diversification, and hedging as practiced by insurance firms. In particular, these practices will include the pooling of worldwide risks. Shiller observes that income and consumption correlations within and across countries indicate imperfect risk sharing, and he argues that large welfare gains can be expected from additional insurance. He elaborates on many of the much-discussed behavioral difficulties of individuals in assessing risks and on the various inconsistencies in decision making, framing problems, and money illusion. He notes that there is reason for hope that these difficulties will be reduced as insurance becomes more extensive.

Shiller’s description of innovations in home insurance is particularly interesting. To mitigate the moral hazard problem (for example, the disincentive for adequate protection of valuable property that results from the promise of restitution of the value of stolen property by insurance), he advocates the use of price indexes that cannot be distorted by any individual’s actions. Country risks can be reduced by indexing payouts to gross domestic product. It should be pointed out that implementation of Shiller’s proposals, with their systemwide implications, requires cooperation among firms, individuals, and countries.

In his chapter, “Finance and Innovation,” Malkiel draws attention to the importance of financial markets in the “free-market innovation machine.” Venture capital firms provide the necessary seed capital and managerial support. This is particularly evident in data that Malkiel presents on the biotech and information technology industries, but it applies to practically all the leading-edge firms. He shows that venture capital firms were successful in screening the more promising innovations and bringing these products to the market. Malkiel presents dramatic figures on the superiority of the United States over Europe in venture capital finance and in initial public offerings, leading to faster growth of these industries in the United States. He also points out the dark side of the abundance of investment outlets, which leads to overinvestment and market bubbles.

Part VIII: Toward Some Lessons

The final part of the book, introduced by Robert J. Strom, features chapters by Edmund S. Phelps and by Eytan Sheshinski. Taken as a pair, these chapters extend the concept of the free-market innovation machine to the critical issues of the performance of the continental western European economies and the economic welfare of developing economies.

The Phelps chapter, “The Economic Performance of Nations: Prosperity Depends on Dynamism, Dynamism on Institutions,” argues that one can view the selection of economic institutions as a key factor in the economic policymaking that is necessary for innovation and growth. Contending that there is an important linkage between the degree of dynamism in a nation’s economy, the development of particular economic institutions, and the nation’s subsequent prosperity, he points to the failure of the continental western European countries to provide the ingredients necessary for the success of a free-market innovation machine. In his critique of policies that resulted in low employment and slow growth, Phelps argues that too much emphasis has been given to neoclassical policy instruments (e.g., tax rates, social contributions, and public expenditures) at the expense of more innovative thinking about policies that will support a well-performing economy. Corporatism specifically, he contends, has been harmful for both productivity and prosperity.

As described by Phelps, corporatism constricts the engine of Baumol’s free-market innovation machine—the innovation that comes from the activity of independent entrepreneurs. In Baumol’s model, corporatism restricts the actions of independent entrepreneurs in favor of a broader social framework for economic and business decisions, thus robbing the free-market innovation machine of the fuel it requires from those entrepreneurs to produce economic growth.

The chapter by Sheshinski, “Pharmaceutical Patenting in Developing Countries and R&D,” examines the potential welfare dilemma inherent in exempting countries from pharmaceutical patents. Sheshinksi’s compelling discussion analyzes the impact of both competitive and monopolistic pricing strategies on global welfare, the economic welfare of the developing country, and the incentives for the firm and industry to engage in research and development expenditures.

A Final Word

It is appropriate that the works in this volume take as their point of departure William Baumol’s Free-Market Innovation Machine. Will Baumol, perhaps more than any other scholar in the last half century, has encouraged our thinking about and advanced our understanding of the role of entrepreneurship and innovation in the growth of capitalist societies. Beginning with his seminal article, from 1968, “Entrepreneurship in Economic Theory” (American Economic Review 58 (2): 64–71), Baumol introduced the entrepreneur as “at the same time one of the most intriguing and one of the most elusive characters that constitutes the subject of economic analysis.” While the entrepreneur remains absent in much of the economics literature, Baumol continues to raise our awareness of the important place of the entrepreneur and innovator in a growing economy. For example, in his book Entrepreneurship, Management, and the Structure of Payoffs (MIT Press, 1993), he examined the allocation of the entrepreneur’s contribution between productive and unproductive activities.

The thoughtful essays included in this volume follow closely from the content of The Free-Market Innovation Machine. Perhaps the best way to make the transition to these discussions is to reproduce part of a May 16, 2002, review of Baumol’s book that appeared in The Economist magazine: “William Baumol has written a splendid new book. Building on the insights of Schumpeter and even of Marx, he argues that it is, above all, the ability to produce a continuous stream of successful innovations that makes capitalism the best economic system for generating economic growth.”3

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